Options-Owner Instruction Manual

This week's Options Forum takes a look at some basic questions on the mechanics of options . To get the best answers, we went to the core of the industry -- the Options Clearing Corp. and Options Industry Council, two Chicago outfits that handle loads of options investor education.

And remember, we're open all night for reader questions, so drop a note to Options Forum and include your full name.

When, Where and How

Let us say, I have purchased a call option on ZZZZ stock for a strike price of $100 and expiration date of January 2002.

Can I exercise my option any time before January 2002 by paying an amount of $100 per share? Does it have to be on the third Friday of the month?

All U.S. exchange-traded equity options give the buyer the right to exercise an options contract at any time prior to expiration . This type of exercise procedure is referred to as "American style." In your example, as the buyer of the call option you have the right to submit an exercise notice to your broker at any time prior to the Saturday following the third Friday in January 2002.

What is the procedure for exercising the option? Is it enough just to inform the broker?

When you want to exercise your call option on ZZZZ stock, you must take your action prior to the expiration of the option by directing your broker to exercise the option. However, in order to ensure that an option is exercised on a particular day, you, the holder of the option, must direct your firm to exercise before the firm's cutoff time for accepting exercise instructions for that day.

Different firms may have different cutoff times for accepting exercise instructions from customers, and those cutoff times may be different for different options. Make sure to ask your broker about specific deadlines.

Assuming that the market price of ZZZZ stock is above $100 on the expiration date, what happens to the option if I do not exercise or sell the option before the expiration date? Would it be automatically exercised or will I have the option to exercise even after the expiration date?

If you do not exercise or sell the option before the expiration date, there are a couple of possible scenarios.

The first scenario is that the contract simply expires, meaning that the option holder no longer has any rights to exercise the option, and the option no longer has any value.

The second scenario depends on your brokerage firm. Certain firms that are clearing members of the OCC can have options contracts that are at or above a specific in-the-money threshold automatically exercised unless the firm instructs OCC to the contrary.

Regardless, most firms require their customers to notify the firm of their intentions to exercise even if an option is in the money.

A call option is considered in the money if the strike price is below the current price of the underlying stock. If ZZZZ stock splits 2-for-1, what happens to the underlying options?

Options contracts are typically adjusted for an equity distribution. A good reference manual to review possible equity-contract adjustments for this scenario is Chapter 3 of the Characteristics and Risks of Standardized Options booklet, available free at www.optionscentral.com.

In your example, after the split, your position would have been adjusted to two contracts with an exercise price of $50.

If the company issues tracking stock for a portion of the business, would I get the tracking stock along with the ZZZZ stock when I exercise the option?

Only if the tracking stock was distributed to ZZZZ shareholders. It's likely that ZZZZ options that are in existence at the time of the distribution would be adjusted on a prorated basis.

Again, we encourage you to check out Chapter 3 of Characteristics and Risks of Standardized Options for more detailed information on adjustments that may be made to certain options contract terms to account for events such as mergers, stock splits and spinoffs.