Stock Option Trading - New Options Clearing Corporation Rule

A few years ago on a Monday morning, I checked my brokerage account and to my surprise it showed that I had purchased 1,000 shares of AMD for a total cost of $15,000. The payment for this purchase was taken out of my brokerage money market account.

Why surprised you may ask. I had not put an order for this purchase nor did I really intend to buy AMD. I get to this in a little bit.

Had I wanted to sell the stock on that day, I would have received around $14,500, a loss of $500 in just a few hours. In the end it worked out and I sold that particular stock a few months later for a handsome profit.

But on that day I had a paper loss of $500 and if I didn't have enough money to pay for the purchase, the $500 loss would have been the least of my worries.

So, how did I end up with a stock that I did not necessarily want or order?

Automatic exercise threshold for equity options is the reason.

Today, I received the following message from two of my brokerage firms that reminded me of that day.

"Beginning October 2006, the Options Clearing Corporation (OCC) will implement a change to reduce the automatic exercise threshold for equity options. The current threshold of $0.25 will be set at $0.05 for expiring options that are automatically exercised by the OCC. The threshold for index options will remain at $0.01."

Who cares about a measly $0.20? You can't even buy a stick of gum with that.

For options traders this could mean a huge potential loss, margin calls and a whole lot of trouble.

Let's go over a few simple reminders about options trading. Options are contracts that allow a person to buy or sell securities, for example stocks, at a predetermined price called option exercise price and on/or before a predetermined date in the future called option expiration date.

Options represent a reserved right but not an obligation. In other words, the holder of this right, that is to say the buyer, can exercise this right or not.

For example if you own a Microsoft January 25 Call Option, it gives you the right to buy Microsoft for $25.00 on or before third Friday in January. It is obvious that you would not exercise your option if Microsoft is at $20.00. In that case, if you really like Microsoft, you just go to open market and buy it for $20.00.

However, if Microsoft soars to $40, then you want to exercise your right (option) and buy the stock at $25 and turn around and sell it at $40 or keep it for further potential increase.

To exercise your options you need enough money to pay for buying the stock. Each option contract represents 100 shares of stocks, so 10 contracts represent 1000 shares of stocks. In our Microsoft example, for you to exercise 10 options contracts at the price of $25.00 requires $25,000 to be in your account.

If you don't have that money, well, you may face margin calls and some other not so pleasant consequence. This is where the new change can cause some serious damage.

Options are a right and not an obligation except that you have to deal with automatic exercise threshold. This is the threshold the Options Clearing Corporation (OCC) uses to determine if they should exercise your right on your behalf.

In the letter I received from my brokerage firm, they informed me that if the price of the stock is only a nickel ($.05) above the exercise price, that would mean they will automatically buy the stock for me according to this new rule.

So what can options traders do not to deal with unwanted stocks?

First, they can and should watch the stock price and be proactive in the process especially on the option expiration date. Option trading is not by any stretch of imagination a passive approach. They can also call their brokerage firm and find out what other alternatives are available to them.

Seasoned options traders know what they should do and the aim of this article is to bring some facts to the attention of those who are just getting started.

In investing and in life I remember what Robert Grant said, "Men and women everywhere must exercise deliberate selection to live wisely."

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