EXERCISE AND SETTLEMENT

Although most option holders and writers close out their options positions by an offsetting closing transaction, investors should nonetheless be familiar with the rules and procedures applicable to exercise. Such an understanding can help an option holder determine whether exercise might be more advantageous than offsetting sale of the option. An option writer needs to understand exercise procedures because of the possibility of being assigned an exercise. Once an exercise of an option has been assigned to an option writer-even though he may not yet have been notified of the assignment-the writer can no longer effect a closing transaction in that option but must instead purchase or sell the underlying interest for the exercise price (or, in the case of a cash-settled option, pay the cash settlement amount).

HOW TO EXERCISE

The period during which an option is exercisable depends on the style of the option. This is discussed under "Style of Option" in Chapter II.

In order to exercise most options traded at the date of this booklet, action must be taken by the option holder prior to the expiration of the option. However, some options may be subject to automatic exercise. For example, capped options are subject to automatic exercise if the automatic exercise value of the underlying interest hits the cap price for the option, and certain other options are subject to automatic exercise at expiration if they are then in the money (or, in the case of some options, in the money by a specified amount).

To exercise an option that is not subject to automatic exercise, the holder must direct his brokerage firm to give exercise instructions to OCC. In order to ensure that an option is exercised on a particular day, the holder must direct his brokerage firm to exercise before the firm's cut-off time for accepting exercise instructions for that day. Different firms may have different cut-off times for accepting exercise instructions from customers, and those cut-off times may be different for different options.

A brokerage firm's cut-off time for accepting exercise instructions becomes critical on the last trading day before an option expires. An option that expires unexercised becomes worthless. An option holder who intends to exercise an option before expiration must give exercise instructions to his brokerage firm before the firm's cut-off time for accepting exercise instructions on the last trading day before expiration. Many brokerage firms accept standing instructions to exercise, or have procedures for the exercise of, every option which is in the money by a specified amount at expiration. These procedures often incorporate by reference OCC's administrative procedures that provide for the exercise of every option that is in the money by a specified amount at expiration unless the Clearing Firm carrying the option in its accounts instructs OCC not to exercise the option. Investors should determine from their brokerage firm the applicable cut-off times, the firm's procedures for submitting exercise instructions, and whether any of their options are subject to automatic exercise. Investors should also determine whether the exercise of their options is subject to standing instructions of their brokerage firm, and, if so, they should discuss with the firm the potential consequences of such instructions.

In highly unusual circumstances (e.g., where a brokerage firm is unable to receive instructions from its customers), a firm may be authorized under applicable rules to make an exception to its regular cut-off time. However, in order for an option to be exercised, the brokerage firm must in any event pass on its customer's exercise instructions to OCC before expiration. OCC may allow exercises for a limited time after expiration in the unlikely event that OCC is unable to follow its normal procedures for receiving exercise instructions from Clearing Members on the expiration date. Subject to that very limited exception, OCC has no authority to extend the expiration of any option.

Once an exercise instruction is given by a Clearing Member to OCC, it cannot ordinarily be revoked except to correct a bona fide error that is specified in a request filed by the Clearing Member prior to a deadline specified in OCC's rules.

ASSIGNMENT

OCC assigns exercises in standardized lots to Clearing Member accounts that reflect the writing of options identical to the exercised options. A description of OCC's assignment procedures is available from OCC on request at the address set forth in paragraph 1 of Chapter Xl of this booklet. Assignments are ordinarily made prior to the commencement of trading on the business day following receipt by OCC of the exercise instruction. In the case of options traded in evening sessions, exercise instructions received by OCC on a business day are ordinarily assigned prior to the opening of trading in that day's evening session.

If exercises are assigned by OCC to a Clearing Member's customers' account, the Clearing Member must then assign them to customers maintaining positions as writers of the exercised options series. The rules of the options markets require their member firms to allocate assignments to customers either on a random selection basis or on a "first-in, first-out" basis and to inform their customers which method is used and how it works. Regardless of the method used, option writers are subject to the risk each day their options are exercisable that some or all of them may be assigned. (See the discussion in Chapter X under "Risks of Option Writers.")

It is possible that an option writer will not receive notification from its brokerage firm that an exercise has been assigned to him until one or more days following the date of the initial assignment to the Clearing Member by OCC. This creates a special risk for uncovered writers of physical delivery call stock options. This is discussed in paragraph 8 under "Risks of Options Writers" in Chapter X and under "Settlement" in this chapter.

SETTLEMENT

Settlements between brokerage firms or their agents on virtually all exercised physical delivery stock options are routinely handled through stock clearing corporations in much the same way as ordinary purchases and sales of the underlying equity security. Promptly after the exercise and assignment of a physical delivery stock option, OCC reports it to the designated stock clearing corporations of the Clearing Members representing the exercising holder and the assigned writer. If neither stock clearing corporation rejects the transaction by a time specified in their agreements with OCC, settlement is effected pursuant to the rules of those clearing corporations, and OCC has no further responsibility to either the exercising holder or the assigned writer.

In a few cases-which usually occur because an underlying equity security is no longer eligible for clearance through a stock clearing corporation-settlements calling for the delivery of that security are made directly between Clearing Members. OCC's rules provide protect procedures for exercise settlements made directly between Clearing Members that involve the delivery of securities which either have been called for redemption, are due to expire or with respect to which a call or expiration date is impending, or are subject to an offer which will expire, if the expiration time (as defined in OCC's rules) is on or after the exercise settlement date for the option. Under these protect procedures, the Clearing Member entitled to receive the securities may give a liability notice to the delivering Clearing Member by a specified cut-off time prior to the expiration time. If a liability notice is so given and the securities are not delivered sufficiently in advance of the expiration time to permit the receiving Clearing Member to obtain their benefit, the delivering Clearing Member will be liable for any resulting damages. If the failure to deliver was the fault of the Clearing Member's customer, the Clearing Member may (depending on its own procedures) pass that liability on to the customer. Investors should be aware that correspondent clearing corporations may have protect procedures in respect of the settlements made through them.

At the date of this booklet, the regular exercise settlement date for physical delivery stock options is the fifth business day after exercise, but the SEC has adopted a rule that requires the regular settlement date to be the third business day after an exercise that takes place on or after June 1, 1995. The regular exercise settlement dates for all other types of physical delivery options traded at the date of this booklet are described in the separate chapters of the booklet discussing those options.

At the date of this booklet, settlements of exercises of cash-settled options and foreign currency options are effected by Clearing Members through OCC. Settlement of exercises of cash-settled options-through the payment in cash of the cash settlement amount-ordinarily takes place on the business day immediately following the day of exercise. However, cash-settled capped options that have been automatically exercised on any trading day other than the one immediately prior to expiration are settled on the second business day after the automatic exercise is triggered. The settlement of exercises of cash-settled options that have a settlement currency that is not U.S. dollars is discussed under "Settlement Currency" in Chapter VII.

OCC has authority to postpone settlement of any option on any type of underlying interest when OCC considers such action to be necessary in the public interest or to meet unusual conditions.

Each brokerage firm involved in an exercise or assignment settles with its own customer. Neither OCC nor any options market has any responsibility to customers with respect to funds or securities that have been received by brokerage firms for their customers. Investors may determine from their brokerage firms when and how settlement amounts will be credited or debited to their brokerage accounts.

In certain unusual circumstances, it might not be possible for uncovered call writers of physical delivery stock and stock index options to obtain the underlying equity securities in order to meet their settlement obligations following exercise. This could happen, for example, in the event of a successful tender offer for all or substantially all of the outstanding shares of an underlying security or if trading in an underlying security were enjoined or suspended. In situations of that type, OCC may impose special exercise settlement procedures. These special procedures, applicable only to calls and only when an assigned writer is unable to obtain the underlying security, may involve the suspension of the settlement obligations of the holder and writer and/or the fixing of cash settlement prices in lieu of delivery of the underlying security. In such circumstances, OCC might also prohibit the exercise of puts by holders who would be unable to deliver the underlying security on the exercise settlement date. When special exercise settlement procedures are imposed, OCC will announce to its Clearing Members how settlements are to be handled. Investors may obtain that information from their brokerage firms.

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