The settlement amount of £200 due to the clearing house is there-
fore receivable from the client. It is important to remember that the
firm that has the clearing account, and the broker at the clearing
house is liable for the settlement of £200 whether or not the client
settled their obligation with the broker.
However, if there had been some kind of error with the trade, for
example the price was given to the client as 20p but the actual trade
in the market was 21p, then the transaction would have shown in
the clearing account and backed off in the error account with a
reversal out of the error account backed off to the client account
(Figure 5.5).
The loss of 1p is reflected in the error account and the client
account shows the transaction details as confirmed to the client. In
settlement terms, the amount of £210 due to the clearing house is
being met by £200 from the client and £10 from the error account
(Figure 5.6).
Option exercise and assignment
The buyer of an option has purchased the right to either take delivery
from call or make delivery to put the writer of the option. The under-
lying will be delivered unless the settlement is in cash format rather
than physical.
Options processing 91
Clearing Account Error Account Client Account
Buy 1 BP Oct. 330 Call @ 21p Buy 1 BP Oct. 330 Call @ 21p
Sell 1 BP Oct. 330 Call @ 20p
Buy 1 BP Oct. 330 Call @ 20p
Clearing
house
Clearing
broker
Client
account
Error
account
£10
£200£210
Figure 5.5 Account Postings
Figure 5.6 Account Postings
The terms under which the buyer may exercise their right are deter-
mined by the ‘style’ of the option. As previously noted there are four
styles of options:
1. American – exercisable on any business day
2. European – exercisable on expiry
3. Bermudan – exercisable at preset timings
4. Asian or Average – exercised against an average underlying price.
In the traded option markets, European and American options
are listed. The process for exercising an option is set out in the rules
and regulations of the clearing house and in the contract spec-
ification published by the exchange on which the option is traded.
The clearing house establishes the method and timings for the exer-
cise of options and the clearing members must adhere to these
procedures.
The decision on whether to exercise an option depends on whether
the option has any intrinsic value. Intrinsic value occurs when the
strike price viewed against the current underlying asset price has a
value. For example, if the underlying price is 100 and the strike price
of a call option is 80 then there is an intrinsic value of 20 because
the holder of the option can exercise the right to take delivery of the
underlying at a cost of 80 when it is priced at 100 in the market. The
option is known as an in-the-money option. However, the put option
with a strike price of 80 and an underlying price of 100 is an out-of-
the-money option because it has no intrinsic value as no one would
want to exercise the option to sell the underlying at 80 when they
could sell it in the market at 100.
• In-the-money A call option where the exercise price is below the
underlying asset price or a put option where the exercise price is
above the underlying asset price. These options are deemed to
have intrinsic value of the in-the-money difference between the
exercise price and the underlying asset price.
• At-the-money An option whose exercise price is equal, or closest,
to the current market price of the underlying asset. This option
has little or no intrinsic value as there is no in-the-money differ-
ence between the exercise price and the underlying asset price.
• Out-of-the-money A call option whose exercise price is above the
current underlying asset price or a put option whose exercise
price is below the current underlying asset price. This option has
no intrinsic value.
92 Clearing and settlement of derivatives
We can see that by knowing whether an option is in- or out-of-the-
money and by knowing the option style we can determine whether or
not the option position will be exercised or assigned. As a result, firms
operating in options will have a report available showing the current
status of the option position. The following is an example of what it
would contain.
Remember, however, that although an option might be in-the-
money, if the option style is European then the buyer cannot
exercise the option unless it is expiry day. For this reason some
investors who wish to avoid an assignment situation write only
European style options and close out the position on expiry day.
It should be noted that as there is a restriction as to when the
holder of a European style option can exercise, the buyer will expect
to pay less premium for the option than they would for an American
style option.
Option Expiry and Exercise Report
Time: 08.30
Date: 16th July 2004 Stock: XYZ plc Stock Price: 332p
Series Status Position Exercise/Assignment
Jul 280 Calls ITM Short Expect assignment
Jul 280 Puts OTM Short No Assignment
Jul 300 Calls ITM Long Exercise
Jul 300 Puts OTM Long Abandon
Jul 330 Calls ITM Long Possible Exercise
Jul 330 Puts OTM Long Possible Exercise
Jul 360 Calls OTM Long Abandon
Jul 360 Puts ITM Long Exercise
Note: The 330 Calls may be exercised but the costs associated
with the delivery of the shares like commission, stamp duty, etc.
may make a client abandon the option if they have not closed
it out in the market before the cessation of trading. A trader or
market-maker paying no fees and exempt from stamp duty would
probably exercise.
Options processing 93
94 Clearing and settlement of derivatives
If the underlying is particularly volatile, the 330 Calls and Puts
could oscillate between in-, at- and out-of-the-money many times in
the last few days before expiry day and on the expiry day itself.
Let us look at the same positions but now at the close of trading
on expiry day.
Option Expiry and Exercise Report
Time: 16.00
Date: 16th July 2004 Stock: XYZ plc Stock Price: 330p
Series Status Position Exercise/Assignment
Jul 280 Calls ITM Short Expect assignment
Jul 280 Puts OTM Short No Assignment
Jul 300 Calls ITM Long Exercise
Jul 300 Puts OTM Long Abandon
Jul 330 Calls ATM Long Abandon/Possible Exercise
Jul 330 Puts ATM Long Abandon
Jul 360 Calls OTM Long Abandon
Jul 360 Puts ITM Long Exercise
Note: With the 330 series being at-the-money it is unlikely that
a client would exercise their position. The underlying is at a
mid-price of 330 but if there is a spread in the underlying market
so that the bid–offer is say 328–332 then it would still be advan-
tageous for a trader/market-maker to exercise, assuming they
can or have traded at the bid or offer in the stock, i.e. they sell
stock at 332 and exercise their call position for delivery at 330.
In general terms, of course, most option positions are taken as parts
of strategies like hedging or exposure-taking and the intention is not to
go to delivery. For that reason many open options are closed out on
expiry for whatever value they may have in the option market, or if they
are deep out-of-the money they are abandoned. Another reason why an
option position, even one with a minimal value, may be traded out on
expiry is to create a realised profit or loss in the accounts. The aban-
donment of the option may not be accounted for in the same way as a
realised profit/loss with, for instance, perhaps resultant tax issues.
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