Tender of Exercise Notices

Almost nothing about tendering an exercise notice is left to the trader. The exchange's exercise rule limits who may tender, the clearing corporation's rules control when and what happens by default, and the exchange also controls the advice forms and the cut-off times that surround it.

Who May Tender an Exercise Notice, and to Whom?

The Cboe exercise rule opens with two qualifications and then states the mechanism.

Subject to the restrictions in the Cboe exercise limits rule, and to such restrictions as may be imposed under the Cboe options transaction and exercise restriction rule or under the Rules of the Clearing Corporation, an outstanding option contract may be exercised.

The exercise happens during the time period specified in the Rules of the Clearing Corporation, by the tender to the Clearing Corporation of an exercise notice in accordance with the Rules of the Clearing Corporation.

The rule then narrows who may do it. An exercise notice may be tendered to the Clearing Corporation only by the Clearing Trading Permit Holder in whose account the option contract is carried with the Clearing Corporation.

Exam Tip: Gotchas

• The exercise window is set by the clearing corporation, not by the exchange. The rule says the contract may be exercised during the time period specified in the Clearing Corporation's Rules.
• The carrying test is measured at the clearing corporation. The only permitted tenderer is the clearing member in whose account the contract is carried WITH the Clearing Corporation, so a firm carrying the customer position but clearing elsewhere is not that member.

How Does Exercise by Exception Work?

The Options Clearing Corporation (OCC) runs expiration exercise under the OCC expiration exercise procedure, which builds the process in three stages.

The report. At or before such time and date as the Corporation specifies with respect to each expiration date, the Corporation makes available to each Clearing Member an Expiration Exercise Report.

Affirmative instructions. On retrieving the report, each Clearing Member may submit exercise instructions in response to it through electronic means the Corporation prescribes. The instructions indicate, for each series listed for each of the member's accounts, the number of option contracts of that series, if any, to be exercised for that account.

Where no contracts of a particular series are to be exercised for a particular account, the Clearing Member may so indicate opposite the title of that series. Instructions must reach the Corporation before such time and date as the Corporation specifies for the expiration date, and instructions to exercise become irrevocable at the time and date the Corporation specifies.

The deemed tender. Each Clearing Member is deemed to have properly and irrevocably tendered an exercise notice, immediately prior to the expiration time for those contracts on each expiration date, in two categories.

• Each option contract listed in the Clearing Member's Expiration Exercise Report that the Clearing Member has instructed the Corporation to exercise.
• Every option contract of each series listed in that report that has an exercise price below the closing price of the underlying security in the case of a call, or above it in the case of a put, by $0.01 or more.

The second category carries an exception and a proviso. The deemed tender does not apply where the Clearing Member has duly instructed the Corporation to exercise none, or fewer than all, of the option contracts of that series carried in that account.

The proviso covers unusual contract terms. For options with an exercise price expressed as a multiple of the per-unit price, that multiple is applied to the closing price in making the calculation.

If a Clearing Member wants such a contract not exercised, it is the Clearing Member's responsibility to give appropriate instructions to the Corporation.

The rule's own interpretation limits what the automatic process means. The exercise thresholds in the deemed-tender paragraph and elsewhere in the rules are part of the administrative procedures the Corporation established to expedite its processing of expiring option exercises by Clearing Members, and are not intended to dictate to Clearing Members which positions in customers' accounts should or must be exercised.

A second interpretation extends the procedures. They apply to flexibly structured equity options, physically settled and cash settled, and to quarterly, monthly, weekly and short term equity options, except that the time when the report is made available and the deadline for submitting instructions may differ from the corresponding times for standard options.

That extension has one carve-out. An American-style flexibly structured option on fund shares that is cash settled and subject to delayed settlement for any deliverable component is not subject to the deemed-tender paragraph.

Exam Tip: Gotchas

• The threshold is stated as a relationship between exercise price and closing price. A call is caught where its exercise price is below the closing price by $0.01 or more, and a put where its exercise price is above it by that amount.
• The automatic tender is irrevocable and back-dated to just before expiration. The member is deemed to have tendered immediately prior to the expiration time, so a later change of mind has nothing to act on.
• The thresholds do not tell a firm what to exercise. The interpretation says they are administrative processing procedures, not a direction about which customer positions should or must be exercised.
• The instruction exception is per account and per series. It applies where the member instructed the Corporation to exercise none, or fewer than all, of the contracts of that series carried in that account.

What Is the Closing Price the Threshold Is Measured Against?

The clearing corporation defines the term rather than leaving it to the market.

Closing price means the last reported sale price for the underlying security during regular trading hours, as the Corporation determines, on the trading day immediately preceding the expiration date, or on the expiration date if the expiration date is a trading day, on such national securities exchange or other domestic securities market as the Corporation determines.

Two failures are handled expressly. Where the underlying security was not traded on that market during regular trading hours on the trading day immediately preceding the expiration date, or was traded but the Corporation cannot obtain a last sale price, the Corporation may exercise its discretion two ways.

• Fix a closing price on such basis as it deems appropriate in the circumstances, including, without limitation, the last regular-hours sale price on the most recent trading day that has one.
• Suspend the application of the automatic-tender paragraph to option contracts for which that security is an underlying security.

During the term of any such suspension, Clearing Members may exercise those option contracts only by giving affirmative exercise instructions.

Exam Tip: Gotchas

• The closing price can come from expiration day itself. It is taken from the trading day immediately preceding the expiration date, or from the expiration date where that date is a trading day.
• A suspension turns off automatic exercise of in-the-money contracts for that underlying. While it lasts, a member exercises only by giving affirmative exercise instructions, and contracts instructed that way are still tendered.

What Is a Contrary Exercise Advice, and How Is It Submitted?

A Contrary Exercise Advice (CEA), also known as an Expiring Exercise Declaration (EED), is a communication that runs in either of two directions.

• Not to exercise an option that would be automatically exercised under the Clearing Corporation's exercise by exception procedure.
• To exercise an option that would not be automatically exercised under that procedure.

A Trading Permit Holder (TPH) may submit one to the Exchange by four routes: the Exchange's Contrary Exercise Advice Form, the Clearing Corporation's electronic system, the Contrary Exercise Advice form of any other national securities exchange of which the Trading Permit Holder also has membership or participant privileges and where the option is listed, or such other method as the Exchange may prescribe.

A CEA may be cancelled by filing an Advice Cancel with the Exchange, or may be resubmitted at any time up to the submission cut-off times, which bind an Advice Cancel as well as a CEA.

Exam Tip: Gotchas

• A contrary exercise advice is not only an abandonment notice. It is equally the instruction to exercise a contract the automatic procedure would leave unexercised.
• The other-exchange route has two conditions. The Trading Permit Holder must also have membership or participant privileges at that exchange, and the option must be listed there.

What Are the Cut-Off Times for the Exercise Decision and the Contrary Exercise Advice?

The Exchange may establish procedures and cut-off times for the submission of exercise advices to the Exchange for noncash-settled equity options. It has done so, and the deadline turns on how the firm submits exercise instructions, on whether the account is a non-customer account, and on whether the Exchange has given advance notice of a modified close.

The Exchange can move the deadline both ways on a case-by-case basis due to unusual circumstances.

Extended cut-offs. The Exchange may establish extended cut-off times for the decision to exercise and for submitting advices. Examples of unusual circumstances include, but are not limited to, increased market volatility, significant bid and offer spreads in underlying securities, or internal system malfunctions affecting market quotes or deliver orders, or both.

Reduced cut-offs. If the Exchange provides advance notice by 1:00 p.m. on the previous business day, it may establish a reduced cut-off time, again case by case and for unusual circumstances. Its example is a significant news announcement scheduled to be released after the close of the business day immediately prior to expiration and pertaining to an underlying security.

The reduced-cut-off paragraph carries a floor. Under no circumstances should the exercise cut-off time and the time for submission of a contrary exercise advice be before the close of trading.

Exam Tip: Gotchas

• The shorter submission deadline is written for non-customer accounts. Where the firm employs no electronic time-stamped procedure the advice is due within 1 hour and 30 minutes, and the rule states that branch for non-customer accounts. A separate 1 hour 30 minute clock runs for the final decision to exercise when the Exchange has given advance notice of a modified close.
• Both lists of unusual circumstances are open. Each is introduced as examples that include but are not limited to what follows, so a different disruption can qualify.
• A reduced cut-off can never precede the close of trading. That floor is stated as a proviso inside the reduced-cut-off paragraph itself.

What Limits an Exercise Instruction on an American-Style Index Option?

No Trading Permit Holder may at any time prepare, time stamp or submit an exercise instruction for an American-style index option series if it knows or has reason to know that the instruction calls for the exercise of more contracts than the then net long position of the account for which it is to be tendered.

The rule defines all three moving parts.

• Net long position means the net position of the account in that option at the opening of business on the day of the exercise instruction, plus the total number of those options purchased that day in opening purchase transactions up to the time of exercise, less the total number sold that day in closing sale transactions up to the time of exercise.
• Account means the individual account of the particular customer, market-maker or non-customer, as that term is defined in the By-Laws of the Clearing Corporation, who wishes to exercise.
• Market-maker transactions are deemed closing. Every transaction in an option series effected by a market-maker in a market-maker's account is deemed to be a closing transaction in respect of the market-maker's then positions in that option series.

No Trading Permit Holder may adjust the designation of an opening transaction in any such option to a closing transaction except to remedy mistakes or errors made in good faith.

Exam Tip: Gotchas

• The net long position calculation uses only two same-day adjustments. It adds opening purchases and subtracts closing sales, each measured up to the time of exercise, and ignores every other same-day activity.
• The account is the individual account of the person who wishes to exercise. It is not the firm's aggregate position, so a firm-level long position does not support a customer's oversized instruction.
• The good-faith exception is narrow. An opening designation may be changed to closing only to remedy mistakes or errors made in good faith.

What Extra Procedures Apply to American-Style Cash-Settled Index Options?

Clearing Trading Permit Holders must follow the procedures of the Clearing Corporation when exercising American-style cash-settled index option contracts issued or to be issued in any account at the Clearing Corporation. Trading Permit Holders must also follow the Exchange's own procedures.

The Exercise Advice. For all contracts exercised by the Trading Permit Holder or by any customer of the Trading Permit Holder on a business day, the Trading Permit Holder must deliver an Exercise Advice in the form or manner the Exchange prescribes, to a place the Exchange designates, no later than 4:20 p.m.

Where trading hours are extended or modified in the applicable option class, the deadline is instead no later than five minutes after the close of Regular Trading Hours on that business day.

The Advice Cancel. Where the Trading Permit Holder or its customer subsequently determines not to exercise all or part of the advised contracts, the Trading Permit Holder must also deliver an Advice Cancel on the same deadline and in the same manner.

Two qualifications. The President or a designee may determine to extend the applicable deadline for delivering these notifications if unusual circumstances are present. Separately, no Trading Permit Holder may prepare, time stamp or submit an Exercise Advice prior to the purchase of the contracts to be exercised if it knew or had reason to know the contracts had not yet been purchased.

Two days the procedures do not apply. The Exercise Advice and Advice Cancel procedures do not apply on the business day prior to expiration in series expiring on a day other than a business day, or on the expiration day in series expiring on a business day.

Halts. Exercises of American-style cash-settled index options, and the submission of the corresponding Exercise Advice and Advice Cancel forms, are prohibited during any time when trading in those options is delayed, halted or suspended, subject to the same four exceptions covered in the lesson on exercise and assignment.

The documentation exception is stated more fully here. Acceptable documentation is ordinarily limited to an Exercise Advice previously transmitted via the clearing corporation's electronic communications system, or a Trading Permit Holder's copy of an Exercise Advice previously submitted to the Exchange.

Exam Tip: Gotchas

• The prohibition during a halt covers the paperwork as well as the exercise. Submitting the Exercise Advice or Advice Cancel form is prohibited alongside the exercise itself.
• The stated deadline does not move for convenience. It moves when trading hours move, or when the President or a designee extends it in unusual circumstances. The five-minute alternative applies where trading hours are extended or modified in the applicable option class, not as a general grace period.
• Acceptable documentation is ordinarily one of two things. A previously transmitted electronic Exercise Advice, or the firm's own copy of one previously submitted to the Exchange.

What Records Must the Firm Keep, and What Happens to a Late Submission?

Each TPH organization shall prepare a memorandum of every exercise instruction received showing the time when the instruction was received. Those memoranda are subject to the records retention rule, which requires preservation for a period of not less than three years, the first two years in an easily accessible place.

Three further interpretations govern conduct around the deadline.

• Filing an exercise instruction, Exercise Advice, contrary exercise advice or Advice Cancel with the Exchange does not serve to substitute as the effective notice to the clearing corporation for the exercise or non-exercise of expiring options.
• Preparing or submitting any of those after the applicable deadline on the basis of material information released after that deadline is, in addition to constituting a violation of the exercise rule, activity inconsistent with just and equitable principles of trade.
• One prepared, time stamped, submitted or accepted in violation of the applicable cut-off time may still be processed and given effect in accordance with and subject to the rules of the clearing corporation, but the Trading Permit Holder that violated the cut-off time will be subject to discipline.

Exam Tip: Gotchas

• A late instruction can be both effective and punished. The clearing corporation may still give it effect while the Trading Permit Holder faces discipline for breaking the cut-off.
• Filing with the Exchange is not notice to the clearing corporation. The two filings are separate, and only the clearing corporation's receipt drives the exercise or non-exercise.
• The memorandum requirement is about timing evidence. It must show the time the exercise instruction was received, which is what makes a cut-off provable.

What Should You Check on Exam Day?

• Confirm the tenderer is the clearing member in whose account the contract is carried with the clearing corporation, not merely the firm holding the customer.
• On an expiration scenario, apply the deemed-tender test using the exercise price against the closing price, and check whether the member gave contrary instructions.
• Ask which direction the contrary exercise advice runs, since it can either abandon an automatic exercise or trigger one that would not happen.
• Check whether the firm uses an electronic time-stamped procedure and whether the account is a non-customer account before choosing between the longer and shorter submission cut-off.
• On an American-style index option instruction, rebuild the net long position from the opening balance, same-day opening purchases and same-day closing sales.