How does Option “Exercise” work?

3 comments Written on August 4th, 2010 by
Categories: Options

Reader M writes in:

I read your article “Of Options and Choices” posted today.

[…]

It would be helpful if you can through some more light on American Options w.r.t. Indian Markets. I know the basics of these option what I want to understand is that at any given point of time there would be hundreds of Options (for a particular stock)  outstanding. Say there are 2 parties to a trade A (seller/writer) and B (Buyer) and B decide to exercise the option before expiry at 5.00PM on any given day. I want to know 2 things:

1. At what price would the position be settled (since options in India are cash settled)

2. How will exchange decide that A is the person on whom the option has been exercised. Does the exchanges keep the one-one mapping of each contact at the backend. E.g. A initially sold and C bought, C sold (closed position) and D bought and so on say there were 20 such transactions before B decide to exercise the option. How will exchange determine the counterparty for the contract.

First, in American options, stocks are settled at the “cash” market value of the stock. Currently, ICICIBank cash trades at 960, while the future trades at 949. If these are the closing prices today, then a buyer can exercise the 940 call and get Rs. 20.

Because of this difference there is a tremendous amount of market manipulation that happens in the cash markets to bump up option exercise prices. I will post about that separately.

Second, who gets exercised? If there are 100 sellers and 100 buyers, and only 30 buyers choose to exercise, which of the sellers get hit? (It’s called “getting assigned”) Answer: The NSE does random assignment of options to sellers.

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About the Author:
http://www.capitalmind.in
The man behind Capital Mind. Deepak is a co-founder at MarketVision, a financial knowledge company. Deepak also provides data research and consulting services, and now lives in Bangalore. Connect with him at deepakshenoy@gmail.com.

3 comments “How does Option “Exercise” work?”

>The start of Physical delivery will further add to the increasing volume in the market.
http://www.business-standard.com/india/storypage.php?autono=402101

>would you mind reducing the number of articles per page, as the page slows down because of the huge size – Bala

>You have mentioned in your article that —"I could, for instance, buy a 5400 call and sell a 5500 call at the same time, creating a call "spread" which gives me a benefit only between 5400 and 5500."

Since call is the right to buy and Put is the right to sell, aren't we selling put and buying call. Please explain , this is a bit confusing. Do we sell call in the F&O market?