Exercise is an instruction a holder gives; assignment is what OCC hands to a writer chosen by a random procedure. Holders exercise about 7 percent of options, a share that has not varied much over the years, and OCC assigns those exercise notices to clearing member accounts at random, per OCC's options assignment FAQ. The condition that turns a quiet contract into a share transaction is the $0.01 exercise-by-exception threshold at expiration, from OCC's exercise FAQ.

The two events happen to different people

The holder decides. The writer finds out. Between them sit two allocations: OCC assigns the notice to a clearing member at random, and that firm then uses an exchange-approved method, usually a random process or first in, first out, to pick which of its short accounts takes it, states OCC's assignment FAQ. The original buyer and the original seller are not matched back to each other, so a writer can be assigned on a contract sold months earlier to somebody who has since sold it on.

Timing is the writer's real exposure. An American-style contract can be exercised on any day the market is open before the expiration date, which means assignment can arrive on any business day, and all standardized equity options are American style, according to OCC's exercise FAQ. One protection is mechanical: because OCC processes closing buy transactions before exercises, a short position closed during that day's trading hours cannot be assigned, the assignment FAQ notes.

The $0.01 threshold decides the default

At expiration, OCC exercises equity options that are in the money by $0.01 or more in customer, firm and market-maker accounts, and index options in the money by $0.01 in all account types, unless it receives contrary instructions, per OCC's exercise FAQ. The exchanges' cutoff for receiving an exercise notice is 4:30 p.m. Central Time, and firms set earlier internal deadlines.

A penny decides it. Below the threshold nothing happens and the contract lapses, and the premium paid for it is spent. Above it, a position the holder never intended to hold arrives in the account the next morning, which is why an instruction not to exercise has to reach the firm before its own deadline rather than the exchanges'.

Example: a $50 call on 100 shares

The Risk Disclosure Statement for Security Futures Contracts works a published example on an equity option: with XYZ stock at $50, a customer buys an XYZ 50 call covering 100 shares at a premium of $5 per share, so the option premium is $5 x 100 = $500. That same document sets out the payoff at expiration: at $65 the holder is ahead $1,000, at $60 ahead $500, at $55 level, and at $50, $45 and $40 the result is the same $500 loss.

Check the arithmetic against the rule. At $65 the call is $15 in the money, worth $15 x 100 = $1,500, less the $500 premium, giving $1,000. At $55 it is $5 in the money, worth $500, which is exactly the premium, so the result is zero. Below $50 there is nothing to exercise, and the loss stops at the $500 paid.

Now apply the threshold. If the stock finishes at $50.01, the call is in the money by $0.01 and is exercised by exception under OCC's rule unless the holder instructs otherwise. The holder pays 100 x $50 = $5,000 for shares worth $5,001, a $1 gain against a $500 premium, and owns a share position the following morning. The assigned writer delivers those 100 shares for $5,000.

That new share position is a separate exposure, funded separately, and whether it can be carried depends on the account type set out in cash and margin accounts.

European-style contracts remove the early path

Cash-settled index options work differently on both counts. Cboe's SPX specifications state that SPX options are European exercise, exercisable only on the expiration date, and settle in cash delivered on the business day following expiration, with the settlement amount equal to the settlement value minus the strike times $100. No shares change hands and no writer can be assigned early.

The right that is being exercised, and the obligation on the other end of it, are separated in rights on one side, obligations on the other; the deadlines around the final day are in expiration is a deadline with consequences.

Source references

Primary sources used for this guide. Follow the links for the original scope, definitions and conditions.