US options in practice

OpeningTwo weeks to go, assigned tonight

You hold 500 shares of XYZ at $110. For a little extra income, you sold 5 calls with a 100 strike that expire in two weeks. On Thursday evening your broker sends a notice: all 5 have been assigned, and your 500 shares have been sold at $100.

The options still have two weeks to go, so why would anyone exercise now? Because tomorrow is the ex-dividend date, and the dividend is $1.20 per share. If the holder keeps the option, the call will have only 0.235 of time value left once the stock goes ex-dividend; by exercising tonight and taking the shares, the holder collects the 1.20 dividend tomorrow. That is 0.965 more per share, or $483 across 5 contracts.

That $483 comes out of your pocket. The $600 in dividends you would have collected is gone, and all you get in return is your $50,000 for the shares two weeks early, plus no longer having to wait for the remaining time value to decay to zero. None of this should be a surprise: if you know the rules, you can work it out before Thursday's close and buy the calls back or roll them to a higher strike in advance.

This chapter is about rules like these. They don't decide whether your view on direction is right, but they often decide how much money you end up with.

2.1American and European style

Stock and ETF options are American-style and physically settled: they can be exercised on any trading day and turn into shares. Index options such as SPX are European-style and cash-settled: they settle only at expiration, in cash, for the difference.

“American” and “European” are just names; they have nothing to do with where the options trade. An American option carries one extra right, so it is never worth less than an otherwise identical European option. The difference is called the early-exercise value. For calls on stocks that pay no dividend, this value is zero and early exercise never pays; for calls on dividend-paying stocks and for deep in-the-money puts, it can be substantial (Section 2.4).

Physical settlement: the option turns into stock

You hold 1 SPY 780 call, and SPY closes at 785 at expiration. The option is exercised automatically and you buy 100 shares of SPY for $78,000. If your account holds only a few thousand dollars, you are immediately short of margin. It works the other way too: if a put you sold is exercised, you must buy 100 shares at the strike; if a call you sold is exercised and you don't own the shares, you become short 100 shares.

Cash settlement: only the difference changes hands

You hold 1 SPX 7,800 call, and the settlement price at expiration is 7,850. Your account simply receives (7,850 − 7,800) × 100 = $5,000 in cash. No shares move in or out, and there is no weekend risk after expiration. What you do need to watch is when the settlement price is set. Standard monthly SPX contracts are AM-settled: the last trading day is Thursday, and the settlement price is calculated from the opening prices of the component stocks on Friday. You have no way to trade around a gap between Thursday's close and Friday's open. SPX weekly and daily contracts (symbol SPXW) are PM-settled and use the closing price on expiration day.

2.2Expiration cycles

Expirations come in three layers: monthly, weekly and daily. An option that is in the money by $0.01 at the close on expiration day is exercised automatically.

• Monthly: the third Friday of each month. If the exchange is closed that day (for example, on Good Friday), expiration moves up to Thursday. Monthly contracts are listed the longest, and for less liquid stocks, open interest tends to concentrate in the monthlies.
• Weekly: most popular stocks and ETFs have contracts expiring every Friday, usually listed a few weeks ahead.
• Daily: a handful of products, such as SPX, XSP, SPY and QQQ, have contracts expiring every day from Monday to Friday. Contracts that expire the same day are often called 0DTE (Chapter 10).
• Long-term: contracts with more than a year to expiration are called LEAPS, and they usually expire in January.

What happens after 4 p.m. on expiration day

Stock options stop trading at 16:00 Eastern time on expiration day (some index and ETF options close at a different time; check the exchange rules). But the end of trading is not the end of the story: the stock keeps trading after hours, and option holders can still change their minds.

The auto-exercise threshold is one cent

The clearinghouse applies “exercise by exception” to expiring contracts: any option that is in the money by $0.01 or more at the closing price is exercised automatically unless the holder submits contrary instructions. For individual traders, this threshold is a trap.

Example: you hold 5 of the 100 calls and mean to sell them before expiration, but forget. Friday's close is 100.03, so the options are 3 cents in the money and are exercised automatically. On Monday your account has 500 more shares and you have to pay $50,015, while the intrinsic value of this exercise is only 0.03 × 500 = $15 in total. For $15, you carried $50,000 of stock over a weekend, and if your account doesn't have the funds, you also face a margin call or a forced sale.

2.3Exercise and assignment

Exercise is the buyer's decision; assignment is the result that lands on a seller at random. The seller can't choose it and can't know it in advance.

1. The holder submits an exercise instruction through a broker (or is exercised automatically at expiration).
2. Instructions go to the Options Clearing Corporation (OCC). It is the central counterparty for all US-listed options: on every trade, the buyer and the seller each actually settle with the OCC.
3. The OCC allocates assignments at random among the clearing members that hold short positions in that contract.
4. The clearing member (your broker or its clearing firm) then allocates them to specific customer accounts, either at random or first in, first out, and must disclose its method to customers.
5. The seller is usually notified before the next trading day's open, and the short option in the account becomes a purchase or sale of stock.

Why early exercise usually doesn't pay

Exercising early captures only the intrinsic value; the time value is thrown away. With the stock at $100, a 30-day 95 call is worth 6.65. Exercising gets you 5.00; selling the option gets you 6.65. That is a difference of 1.65, or $165 per contract. So for a holder who wants out, selling the option is almost always better than exercising.

For calls on stocks that pay no dividend, this holds strictly. As Chapter 1 showed, the time value of an in-the-money call always includes at least the “interest on the strike,” which is always greater than zero. Exercising early means paying the strike early and giving up that interest for nothing. Only two situations can overturn this conclusion; the next section covers them.

2.4Two reasons for early assignment

Early exercise pays in only two situations: for a call before an ex-dividend date, when the dividend is larger than the remaining time value; and for a deep in-the-money put, when the interest on the strike is larger than the put's remaining “rebound value.”

Reason 1: dividends

At the open on the ex-dividend date, the stock drops by roughly the amount of the dividend, and option holders don't receive the dividend. At the close on the day before the ex-dividend date, a call holder has two choices:

• Exercise today: take the shares, worth S − K, and collect the dividend tomorrow.
• Keep holding: tomorrow the stock becomes S − D, and the option is worth its new intrinsic value plus the remaining time value.

Subtract one from the other and the stock price itself cancels out, leaving a very simple comparison:

The threshold stock price is about 105.30: above it, exercising pays more. The threshold moves with conditions. With a dividend of only 0.50, it rises to 110.44; with 60 days left after the ex-dividend date, it rises to 115.41, because the more time remains, the larger the time value and the less it is worth giving up for the dividend. The deeper in the money the stock, the closer the put value gets to zero, and the time value approaches its floor: the interest of 0.219.

Timing matters too. US stocks now settle T+1, so the ex-dividend date is the record date. To get the dividend, the holder must exercise on the trading day before the ex-dividend date so the shares arrive by the record date. That is why early assignment almost always happens the night before the ex-dividend date.

Reason 2: interest

With a deep in-the-money put, exercising early gets you the strike in cash right away, and that cash starts earning interest. The cost is giving up the chance that the stock rebounds above the strike, and that chance is worth exactly the price of the call at the same strike. By put–call parity, the time value of a European put is:

In numbers: strike 100, 60 days left, IV 30%, rate 4%. The interest on the strike is 100 × (1 − e^{−0.04×60/365}) = 0.655.

European time value turns negative below a stock price of about 86.05, a signal that early exercise is “starting to be worth considering.” But the optimal boundary for the American option is lower, around 80.6: between 80.6 and 86, waiting and exercising once the put is deeper is still better than exercising right away. The exact boundary has to be computed with an American pricing method such as a binomial tree; the Black-Scholes formula itself can't give it.

Interest rates determine how often this comes up. With the same 60 days, at a 1% rate the American boundary falls to 75.3; with rates near zero, a deep in-the-money put has almost no reason to be exercised early. The shorter the time left, the closer the boundary is to the strike: at a 4% rate with 30 days left, the boundary is at 84.7.

2.5Reading an option chain

An option chain is a table of quotes, with one page per expiration and one row per strike. Look at the bid and ask first, then volume and open interest, and the theoretical measures last.

Below is a simulated option chain: XYZ at 102.35, expiring in 30 days. The quotes are generated from Black-Scholes plus an assumed volatility skew and bid–ask spreads; volume and open interest are made up.

① Bid

The highest buy order in the market: the price at which you can sell immediately.

② Ask

The lowest sell order in the market: the price at which you can buy immediately. The midpoint between the two is called the mid price (Mid); some brokers show it as Mark.

③ Volume

Contracts traded so far today. It starts from zero every day.

④ Open interest

The total number of contracts in the market that have not been closed. The clearinghouse updates it once a day after the close; it doesn't change during the session.

⑤ Delta

How many shares one contract is equivalent to (multiply by 100). It can also serve as a rough probability of finishing in the money (Chapter 4).

⑥ Strike

The spine of the chain. A bar marks where the current price sits; the calls above it and the puts below it are in the money.

⑦ Implied volatility

The volatility backed out from the mid price. Here the lower strikes have higher IV; this “skew” is normal for stock options (Chapter 6).

One chain, three levels of liquidity

• 105 call: bid 2.28, ask 2.35, a spread of 0.07, only 3.0% of the mid; 2,240 contracts traded today and open interest is 8,400. Liquid: an order at the mid will probably fill.
• 112.5 call: 0.41 / 0.52. A spread of 0.11 looks small, but it is 23.7% of the mid. Buy and then sell right away, and nearly a quarter of your money is gone.
• 92.5 call: 10.65 / 10.85, a spread of only 1.9% of the mid, but only 12 contracts traded today and open interest is 150. The percentage looks good, but a round trip actually costs $20 per contract, and there may be few real counterparties behind the quotes.

Another column you'll often see is the last traded price (Last). For thinly traded contracts, it may be hours old and have nothing to do with the current quotes. Base both valuations and orders on the bid, the ask and the mid.

2.6Accounts, approval levels and margin

What you can trade depends on two things: the options approval level your broker grants you, and whether your account is a cash account or a margin account.

Some brokers put cash-secured puts in Level 1; some combine the two kinds of naked selling into one level. Approval usually depends on the trading experience, income, net worth and investment objectives you report. The logic of the levels is clear: the higher you go, the harder it is to put a bound on the maximum loss.

Cash accounts and margin accounts

• Cash account: you pay for options in full. Selling a put requires setting aside the full amount in cash; for example, selling one 90 put for $40 ties up 90 × 100 − 40 = $8,960. A covered call requires owning 100 shares. Most brokers don't allow spreads in a cash account. Proceeds from a sale can be used again only after settlement (T+1 for options).
• Margin account: you can borrow to buy stock (Reg T initial margin is 50%), and you can trade spreads and sell naked. Options themselves generally can't be bought with borrowed money: options expiring within 9 months must be paid for in full, and longer-dated options can be financed up to 25%.

Reg T and portfolio margin

US brokers use Reg T rules by default, which calculate margin for each position with a fixed formula. The standard formula for a naked stock option is:

Example: stock at 100, sell a 30-day 90 put (0.40). The margin is 0.40 + max(20 − 10, 9) = 10.40, or $1,040 per contract; minus the $40 received, $1,000 is actually tied up. The same trade in a cash account would tie up $8,960.

Portfolio margin takes a different approach: it reprices the whole portfolio under a set of price scenarios and uses the largest loss as the margin. The scenario range is ±15% for individual stocks and roughly −8% to +6% for broad market indexes. Counting only the price shock, with volatility unchanged, the 90 put above is worth 5.92 if the stock falls 15%, so portfolio margin is about 5.92 − 0.40 = 5.52, or $552 per contract, roughly half of Reg T. Portfolio margin generally requires at least $100,000 in account equity; the minimum varies by broker.

Margin calls

When account equity falls below the margin requirement, your broker issues a margin call. The example below shows how fast it can come.

Your account has $20,000, and you sell 15 of the 90 puts above for 0.40. Reg T requires 15 × $1,000 = $15,000, which looks like room to spare. Two days later the stock falls to 92, panic pushes IV to 40%, and the put rises to 2.98:

• Unrealized loss of (2.98 − 0.40) × 1,500 = $3,870; account equity drops to $16,130.
• The margin requirement rises to 15 × (20% × 92 − 2) × 100 = $24,600.
• A shortfall of $8,470. The stock fell only 8%, and you have to put in more than 40% of your starting capital.

2.7Orders and liquidity

Use only limit orders for options, and combo orders for multi-leg trades. Judge liquidity by three numbers: the spread as a share of the premium, open interest and volume.

Order types

• Market orders: avoid them for options. When spreads are wide, or quotes are unstable in the first few minutes after the open, a market order can fill at an absurd price.
• Limit orders: the standard approach is to start at the mid and, if you don't get filled, move a cent or a few cents toward the other side every 30 seconds to a minute. This is called “walking the order.”
• Combo orders: multi-leg trades such as spreads and straddles are submitted as a single order at a net price, and the exchange fills all the legs at once. Placing the legs separately (“legging in”) risks one leg filling while the price of the other runs away.
• Stop orders: stop orders on options are usually triggered by the option's own price, so a momentary widening of the spread can trigger one by mistake and fill it at a terrible price. Many traders use alerts on the underlying stock's price instead and then place limit orders by hand.

The bid–ask spread is a real cost

If you pay the ask to buy and take the bid to sell, a round trip costs the entire spread:

Three measures of liquidity

These thresholds come from simple arithmetic: the real expected edge of an options trade is often only in the low teens as a percentage of the premium, or less. If the round-trip spread takes 10%, most of the edge is gone. So the thresholds aren't absolute. A trade you plan to hold to expiration, without closing it early, pays the spread only once; for trades you get in and out of often, multiply the spread's impact by the number of trades (Case 3).

The minimum tick also affects the spread. Products in the “Penny Program” are quoted in $0.01 increments below $3 and in $0.05 increments above $3; SPY, QQQ and IWM are quoted in $0.01 at every price. Products outside the program use $0.05 and $0.10, respectively. For an option worth only 0.20, a spread of just one tick is already more than 5%.

2.8Tax concepts

How options are taxed depends on the underlying: broad-based index options get the Section 1256 60/40 treatment, while stock and ETF options are taxed as ordinary capital gains. The wash sale rule applies to options too.

Section 1256 contracts and 60/40

Broad-based index options such as SPX, XSP, NDX and RUT (as well as futures) are “Section 1256 contracts,” with two special rules:

• 60/40: however long you hold, gains and losses are taxed as 60% long-term and 40% short-term capital gains.
• Year-end mark-to-market: positions still open on the last trading day of December are treated as sold at that day's market value, so unrealized gains and losses also count for that year.

Options on ETFs such as SPY and QQQ generally aren't Section 1256 contracts; gains and losses on positions held a year or less are taxed as short-term capital gains. For people who trade often and hold briefly, the difference can be large.

Example (tax rates are assumptions): short-term capital gains are taxed at 32%, long-term at 15%. The blended 60/40 rate is 0.6 × 15% + 0.4 × 32% = 21.8%. On the same $10,000 of short-term profit, SPX options would owe about $2,180 and SPY options about $3,200, a difference of $1,020. In the top federal bracket, the two rates are 26.8% and 37% (not counting state taxes and other surtaxes).

The wash sale rule

If you sell a security at a loss and buy a “substantially identical” security within 30 days before or after the sale, the loss can't be deducted now; instead it is added to the cost basis of the new position and deferred. For options, this matters in two ways:

• Buying a call on the same stock within 30 days after selling the stock at a loss counts as acquiring an option to buy that stock and generally triggers a wash sale.
• Options can also trigger it among themselves: you close a call at a loss, then within 30 days buy a call on the same underlying with similar terms. In some cases it isn't clearly defined which options count as “substantially identical.”

Example: on October 1 you sell 100 shares of XYZ at a $1,500 loss, and on October 15 you buy 1 XYZ call. That $1,500 loss generally can't be deducted now; it is added to the cost of the call instead. Also, for shares you receive through assignment, the premium goes into the cost basis: if you sold a 90 put for 0.40 and were assigned, the tax basis of the shares is 89.60.

2.9Choosing your index exposure

SPY and QQQ suit small accounts and strategies that need stock delivery; SPX, XSP and NDX suit traders who don't want early assignment, want cash settlement or care about taxes.

The notional values in the table below use assumed levels: SPX 7,800, SPY 780, NDX 30,000, QQQ 740.

The difference in size shows up directly in the price. At an IV of 16%, a 30-day at-the-money call costs about $1,557 per contract on SPY and about $15,566 on SPX. One SPX contract carries the same exposure as 10 SPY or 10 XSP contracts.

How to choose

• A small account, or a strategy that needs the stock (covered calls, selling puts to take delivery of shares): use SPY or QQQ. SPY and QQQ options are among the most liquid of all options.
• Trading spreads without early assignment: use SPX or XSP. With cash settlement, accidents like Cases 1 and 2, where “one leg turns into stock,” can't happen.
• A US tax resident who trades short term a lot: the 60/40 treatment of SPX and XSP can save a meaningful amount of tax over a year.
• You want SPX rules but have a small account: XSP is one-tenth the size of SPX. The trade-off is that it doesn't trade as actively as SPX or SPY, its spread as a share of the premium is usually higher, and you need more patience with your orders.
• Nasdaq-100: one NDX contract has a notional value of about $3 million and is used mainly by institutions; individual traders mostly use QQQ.

CasesThree cases

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