DEFINITION of 'Automatic Exercise'

Automatic exercise is a procedure implemented to protect an option holder where the Option Clearing Corporation (OCC) will automatically exercise an "in the money" option for the holder, typically at an option's expiration date and time. For ordinary listed equity options in the United States, expiration typically falls at the end of trading on the third Friday of every month. With automatic exercise, a trader or investor who forgets about the date, or who is otherwise unable to manually instruct their broker or clearing firm to exercise their in the money options, will have the benefit of having their profitable contracts taken care of on their behalf.

BREAKING DOWN 'Automatic Exercise'

Options contracts give their holders the right, but not the obligation, to buy (for a call option) or sell (for a put option) a set amount of the underlying security at a pre-determined strike price, on or before the contract's expiration date (for an American style option. European options can only be exercised upon expiration).

Say a trader purchases the $50 strike call on XYZ shares when the stock is trading at $40. This gives the trader the right to purchase XYZ stock for $50 in the future. At expiration, if XYZ shares have risen to $42, the trader will let the calls expire worthless because there is no benefit to buying the stock for $8 higher than the current market price. However, if the price of the stock rises to $60, the trader will want to exercise his right to purchase shares at $50 in order to make an immediate $10 profit per share.

But, suppose the trade forgets that it is the third Friday of the expiration month - or does not have access to his broker because he is on vacation, or otherwise indisposed. If he fails to exercise his in the money options, he will lose the profit opportunity. Fortunately, the OCC - which is the central clearing house for all listed options traded in the U.S. - and options exchanges will automatically exercise these options on his behalf.

The Options Clearing Corporation has provisions for the automatic exercise of certain in-the-money options at expiration, a procedure also referred to as "exercise by exception." Generally, the OCC will automatically exercise any expiring equity or index call or put in a customer account that is $0.01 or more in-the-money at expiration. However, a specific brokerage firm's threshold for such automatic exercise may or may not be the same as OCC's (although most are). For example, if you own a call option with a strike price of $50, and the stock closes at $50.01 on the day your call expires, your broker will most likely exercise your option.

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