Hi guys, What is the process of exercising an ITM option ? The reason I am asking is that from what I have read and also an exercise request that I tried to put on the IB TWS platform (paper account), it appears that exercise is not similar to other regular orders such as buy or sell order i.e. when we place a Buy or Sell, the orders go to the exchange and get traded. But exercise seems more like a request form which the brpker will manual perform ? Is that correct ? Or do the exercise orders also get done like a limit order ? Basically looking to understand the steps involved from placing the exercise request to the completion of that request. And whether they are manual and how long does it take to be completed when the exercise order is created. Also will the exercise be at market price or the limit price or the strike price of ?
Thank you for the reply OptsOptsOpts If the opt is a put to hedge for a long underlying, is it still better to sell the put (and the underlying) or is it better to exercise to close the long underlying along with the opt?
Exercise procedures are semi-manual for the most part. You must place a request with the brokerage to confirm that you wish to exercise the option. This is usually by phone unless they provide a way to do it otherwise. After the broker confirms your request via a Registered Representative, they will perform the exercise. This will result in one of 2 things depending on what type of option it is: 1. Call - They will purchase the shares for you at the strike price, less a normal trading commission. Your account will be debited for the purchase + commission cost. You will then hold long shares in the account. 2. Put - They will sell the shares for you at the strike price, or will become short the shares at the strike price, depending on whether you owned shares long originally. You will also be charged a commission for the trade. Your account will be credited for the proceeds of the stock sale, less the commission. If you didn't own shares prior to exercise, you will be short stock in the account afterwards. The process will not be quick, it could take some minutes. If you are needing a quick exit, it is probably better to sell the in-the-money option. Usually exercise is best for the following cases: 1. You have a covered call that went in-the-money and you do not wish to keep the stock, and do not wish to sell another covered call on it ( rolling out ). In this case, you normally do nothing and the brokerage auto-exercises the option on your behalf just prior to expiration. 2. The bid/ask spread is wide and you can't get a fair price to exit. Could happen if the option is way in the money. In this case, you exercise to be able to exit the position at a better price. Note, you will need the cash in your account to perform the exercise for this to work. 3. You own an in-the-money call with zero time value on a stock that is reporting a dividend, and you want to buy the stock to own it for the dividend. In this case, you need to exercise the option the day prior to ex-dividend date. 4. You were holding some sort of spread and the short leg got assigned to you. In this case, you may need to exercise the long options in the spread to neutralize the resulting position.
You don't need to have zero time value for an exercise to be worth it. It just needs to be less than the upcoming dividend.
It's been 12 years or so since I used IB's paper trading account so I can't tell you how it works with that. In a real account, the moment you exercise a long ITM option, the transaction occurs at the strike price. If you are closing a position in the underlying, that position disappears. If you have no existing position in the underlying, the new position is long or short shares depending on whether you exercised a call or a put. I have no clue what the source of new long or short shares are, nor do I care. My execution achieves the goal and I'm free to buy or cover the newly opened underlying position immediately (assuming that I had no position that the exercise was closing).
If the option's bid is trading below intrinsic, execute the offsetting trade in the underlying first (short the underlying if exercising calls or buy stock if exercising puts and then exercise). This discount arbitrage locks in the gain and avoids market risk. I never get why people want to exercise to capture the dividend since a dividend doesn't increase the value of the account and if it's a non sheltered account, the dividend is taxable.
Can you provide an example with actual prices that demonstrates that exercising an ITM call with time premium remaining (and less than the upcoming dividend) is worth it?