Exercise and Assignment

Exercise and assignment are two ends of one event. The holder tenders, the clearing corporation assigns, and the firm carrying the short side must already have fixed procedures deciding which customer receives it.

Who Can Exercise, and When?

The Cboe definitions fix the exercise window by style, and each definition is qualified twice.

• An American-style option is an option contract that, subject to the Cboe exercise rule and to the Rules of the Clearing Corporation, may be exercised on any business day prior to and on its expiration date.
• A European-style option is an option contract that, subject to the same rule and the same Clearing Corporation Rules, may be exercised only on its expiration date.

The definitions also settle a naming point that matters for reading every other rule here. The terms Clearing Corporation and Options Clearing Corporation (OCC) both mean the same body.

Exam Tip: Gotchas

• The American-style window includes expiration day. It runs on any business day prior to AND on the expiration date, so a choice describing it as "before expiration only" is short by a day.
• Both style definitions are subject to other rules. They are written subject to the Cboe exercise rule and to the Clearing Corporation's Rules, so a restriction imposed under either can close a window the style definition appears to leave open.

Who Assigns, and Who Allocates?

Assignment happens in two steps at two levels, and only the second one belongs to this unit.

The clearing corporation assigns an exercise notice to a clearing member. That step, and the clearing corporation's own procedures for it, are covered in the unit on clearance and settlement.

The member level is what the Cboe exercise notice allocation rule governs. Each Trading Permit Holder (TPH) organization shall establish fixed procedures for the allocation of exercise notices assigned in respect of a short position in that organization's customers' accounts.

The allocation rule does not apply to binary options or credit default options.

Exam Tip: Gotchas

• The allocation rule reaches customers' accounts. It governs how the firm distributes an assigned notice among the short positions its customers hold, not how the clearing corporation picked the firm.
• The procedures must be fixed in advance. The rule requires established fixed procedures, so a firm deciding case by case has a violation even if each individual choice looks fair.

Which Allocation Methods May a Firm Use?

The rule names the permitted bases and closes the list.

Random selection is not a free-standing option. The automated form needs Exchange approval, and the manual form must be a basis the Exchange itself specified.

Exam Tip: Gotchas

• Last in, first out is not among the general bases. The general paragraph names only first in, first out, an automated random selection basis approved by the Exchange, and a manual random selection basis specified by the Exchange.
• The two random branches carry different words. The automated basis must be approved by the Exchange; the manual basis must be one the Exchange has specified.

What Does the Firm Owe Its Customers and the Exchange?

Three obligations attach to whichever method the firm adopts.

Disclosure. Each TPH organization shall inform its customers in writing of the method it uses to allocate exercise notices to its customers' accounts, explaining its manner of operation and the consequences of that system.

Reporting and approval. Each TPH organization shall report its proposed method of allocation to the Exchange and obtain the Exchange's prior approval, and no TPH organization shall change its method unless the change has been reported to and approved by the Exchange.

That reporting paragraph has an exception. Its requirements are not applicable to allocation procedures submitted to and approved by another self-regulatory organization (SRO) having comparable standards pertaining to methods of allocation.

Retention. Each TPH organization shall preserve for a three-year period sufficient work papers and other documentary materials relating to the allocation of exercise notices to establish the manner in which allocation of those notices is in fact being accomplished.

Exam Tip: Gotchas

• The written disclosure has two required parts. Naming the method is not enough; the firm must explain its manner of operation and the consequences of that system.
• A change needs approval too, not just notice. The rule bars a change unless it has been reported to and approved by the Exchange.
• The retention standard is about proof, not paperwork. The materials preserved must be sufficient to establish how allocation is in fact being accomplished over the three-year period.

When Can the Board Restrict a Transaction or an Exercise?

The Cboe options transaction and exercise restriction rule empowers the Board to impose restrictions on transactions or exercises in one or more series of options of any class dealt in on the Exchange.

The standard is the Board's own judgment: restrictions it deems advisable in the interests of maintaining a fair and orderly market in option contracts or in underlying securities, or otherwise deems advisable in the public interest or for the protection of investors.

While such a restriction is in effect, no Trading Permit Holder shall, for any account in which it has an interest or for the account of any customer, engage in any transaction or exercise in contravention of it.

The rule then protects the run-up to expiration, and splits the protection by product.

• For a series other than index options, during the 10 business days prior to the expiration date of that series, no restriction on exercise may be in effect.
• For index options, restrictions on exercise may be in effect until the opening of business on the last business day before the expiration date.

Exam Tip: Gotchas

• The pre-expiration protection covers exercise, not transactions. The 10-business-day window bars a restriction on EXERCISE in that series; a restriction on transactions is not what the sentence addresses.
• Index options get almost no pre-expiration protection. A restriction on exercising them can run until the opening of business on the last business day before expiration.

When Are Exercises of American-Style, Cash-Settled Index Options Prohibited During a Halt?

Exercises of American-style, cash-settled index options are prohibited during any time when trading in those options is delayed, halted or suspended. The rule then states four exceptions.

• The exercise may be processed and given effect in accordance with and subject to the rules of the Clearing Corporation if it can be documented, in a form prescribed by the Exchange, that the decision to exercise was made during allowable time frames prior to the delay, halt or suspension.
• Exercises of expiring American-style, cash-settled index options are not prohibited on the last business day prior to their expiration.
• Exercises are not prohibited during a trading halt occurring at or after 4:00 p.m. In that event exercises may occur through 4:20 p.m., and if trading resumes, during the resumption and for five minutes after the close of the resumption.
• The President or a designee may determine to permit the exercise while trading is delayed, halted or suspended.

The exception for a trading halt occurring at or after 4:00 p.m. is itself subject to the Board's authority to impose restrictions on transactions and exercises, described under the heading When Can the Board Restrict a Transaction or an Exercise?

For an American-style, cash-settled flexible exchange (FLEX) index option, the references to a trading delay, halt, suspension, resumption or closing rotation mean the occurrence of that condition in the standardized option on the index underlying the FLEX option, rather than in the FLEX option itself.

The same rule carries an interpretation letting the underwriters of a public underwritten distribution in which the issuer is engaged, or proposes to engage, request that the Exchange restrict uncovered opening writing at a discount in call options on the underlying security, where the distribution is of that security or of securities exchangeable for or convertible into it.

The rule's last paragraph is worth reading exactly as printed: binary options and index options are not subject to the halt paragraph above or to the underwriter-restriction interpretation. The rulebook prints that carve-out alongside a halt paragraph written entirely about index options, and this course teaches both sentences as the rulebook states them rather than resolving them.

Exam Tip: Gotchas

• The documentation exception is about timing, not intent. What must be documented, in the Exchange's prescribed form, is that the decision to exercise was made during allowable time frames before the delay, halt or suspension.
• The late-halt exception has two clocks. Exercises may occur through 4:20 p.m., and separately during any resumption and for five minutes after that resumption closes.
• A FLEX index option reads its halt conditions from another contract. The delay, halt, suspension, resumption or closing rotation is measured in the standardized option on the underlying index.

What Should You Check on Exam Day?

• Identify the exercise style first, and remember the American-style window includes the expiration date itself, subject to any restriction in force.
• On an allocation question, test the method against the three permitted bases and check that a random method carries its Exchange approval or specification.
• On a halted American-style cash-settled index option, work through all four exceptions before concluding the exercise is prohibited.