Option Exercise & Assignment Explained

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Option Exercise & Assignment

Exercise

To exercise an option is to execute the right of the holder of an option to buy (for call options) or sell (for put options) the underlying security at the striking price.

American Style vs European Style

American style options can be exercised anytime before the expiration date. European style options on the other hand can only be exercised on the expiration date itself. Currently, all of the stock options traded in the marketplaces are American-Style options.

When an option is exercised by the option holder, the option writer will be assigned the obligation to deliver the terms of the options contract.

Assignment

Assignment takes place when the written option is exercised by the options holder. The options writer is said to be assigned the obligation to deliver the terms of the options contract.

If a call option is assigned, the options writer will have to sell the obligated quantity of the underlying security at the strike price.

If a put option is assigned, the options writer will have to buy the obligated quantity of the underlying securty at the strike price.

Once an option is sold, there exist a possibility for the option writer to be assigned to fulfil his or her obligation to buy or sell shares of the underlying stock on any business day. One can never tell when an assignment will take place. To ensure a fair distribution of assignments, the Options Clearing Corporation uses a random procedure to assign exercise notices to the accounts maintained with OCC by each Clearing Member. In turn, the assigned firm must use an exchange approved way to allocate those notices to individual accounts which have the short positions on those options.

Options are usually exercised when they get closer to expiration. The reason is that it does not make much sense to exercise an option when there is still time value left. Its more profitable to sell the option instead.

Over the years, only about 17% of options have been exercised. However, it does not mean that only 17% of your short options will be exercised. Many of those options that were not exercised were probably out-of-the-money to begin with and had expired worthless. In any case, at any point in time, the deeper into-the-money the short options, the more likely they will be exercised.

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Option Exercise & Assignment Explained

Option exercise and assignment are two fundamental principals of options trading but can be very confusing to a new options trader. We quickly understand some parts of options because we can find similarities from our history of stock trading. Unfortunately, exercise and assignment are not one of those similarities.

Unlike with straight stock trading, there are many different ways to close out an option. Some of these ways are dependent on if you are long or short or what your trading goals are. Most you have control over, but there are some ways where you give up your control.

As we discuss what exactly exercise and assignment are we will also talk about the many different ways you can close out an option and when exactly you should do it. We will dig into more advanced topics such as the effect of dividends and how they can change when you should close out an option.

What Is Option Exercise?

Before we break out the textbook definition of exercising an option, let’s back up and talk about who should deal with exercising and who gets the assignment.

Like stock you can go long or short options: long call, short call, long put and short put. If you go long a call or long a put you are the buyer, you hold the power in this option contract. To enter into this trade, you are ‘Buying to Open’ your call or put. This also means you do not have to worry about option assignment, and you get to deal with option exercise.

If you go short a call or short a put, you are the seller, writer, and you are obligated to fulfill the requirements of your option contract. To enter into this trade your are ‘Selling to Open’ your call or put. If you are short a call or a put you have to think about option assignment.

When you are the buyer of an option, you have a couple of ways you can close that option out. You can either close the option in the market, let it expire worthless or exercise the option.

According to Brain Overby of all the options in the market approximately 17% are exercised, 35% expire worthless, and 48% are closed out in the market.

Closing out an option in the marketplace is the most used method. This is because it is the most like trading regular stock and can be used whenever you need.

You can close out an option in the market if:

You are either long or short your option

It is currently trading at a profit or a loss

It is before or at its expiration date

Basically whenever and wherever you feel like it

Let’s look at some examples to make more sense of this.

The Option Prophet (sym: TOP) has a call options trading for $5.00 and expires in two months. We decide that TOP is going to go up in price, so we want to get long this call, we ‘Buy to Open’ our call for $5.00. We ended up being right about our decision and TOP has begun to move higher. Even though it is only two weeks after we have bought our call it is now trading for $8.00. We decide that move is good enough for us, so we want to close our position and take the profit. We go back to our order screen and ‘Sell to Close’ our call for $8.00. We made a $3.00 profit on the play.

Later down the road, we see TOP has remained elevated, and we think it is going to move lower. Instead of longing a put we decide to short a call (bearish position) for $3.00. To enter this position we ‘Sold to Open’ our call. Unfortunately, this time we were wrong and the momentum in TOP has pushed it higher. Now our call is worth $5.00, and we decide we have had enough and wanted to close the position in the market. We go back to our order screen and enter a ‘Buy to Close’ order for $5.00. We lost $2.00 on this trade.

Letting an option expire worthless is the easiest method to use, but it either means you are taking the full loss or the full gain depending on the position.

You can let an option expire worthless if:

You are either long or short your option

The option is at expiration

The first thing you should notice about allowing an option expire worthless is that it has to be at expiration. This is a situation where you don’t have to do anything or enter any orders. The option will expire and disappear from your account and never be heard from again. The beautiful part about an option expiring worthless is that you do not have to pay a commission to close the position.

Again, examples will help us illustrate.

You believe TOP is going to make a huge move lower, so you are going to go long some deep out-of-the-money puts for $0.50 that expire next week. Unfortunately this time you got the direction wrong, and TOP moved higher dropping the value of your puts. Since the puts are not worth anything anymore, you are just going to let them run their course. At expiration, your puts will be worth $0. The contracts will be removed from your account, and you will have a total loss on that position.

You now realize you can’t bet on TOP going lower, so you want to get short puts (bullish play). You see some out-of-the-money puts worth $1.50 and you ‘Sell to Open’ those contracts. This time your decision was right as TOP launches higher and never looks back. Your puts quickly drop in value (a good thing). You decide your position is safe and you are going to hold your short puts till expiration. At expiration, your puts will be worth $0. The contracts will be removed from your account, and you will have a total gain on that position.

All out-of-the-money options go to $0 at expiration. These are the only options that can expire worthless. In-the-money options CANNOT expire worthless. If you are long options that expire worthless, you will have a loss. If you are short options that expire worthless, you will have a gain.

Now that we’ve made it through the different ways to close an option we can begin to discuss exercise.

The buyer of a call option has the right to buy shares at the strike price. This is the basic definition of a call option and deals explicitly with the right to exercise your option. Merely put exercising your call option trades your option in for the underlying.

The buyer of a put option has the right to sell shares at the strike price. This is the basic definition of a put option and, again, deals explicitly with the right to exercise your option. Merely put exercising your put option trades your option in for short shares.

You can exercise an option if:

You are long a call or put option

It is true that there is only one requirement, but we will have rules of when you should and shouldn’t exercise your option.

Another TOP example!

You are currently long two call options on TOP at the $50 strike. TOP is currently trading at $55.00 (your option is in-the-money), and you think this is going to be an excellent long-term hold, so you want to exercise your option and pick up the shares. When you exercise, you will get rid of your option contracts and convert them into 200 shares (because we had two contracts) on TOP at $50/per share. This gives you a total price of $10,000.00. As you can see TOP is currently trading at $55.00 so you start with a profit of $1,000 (200 x 55 – 10,000). What you don’t want to do is just turn around and sell your shares to collect that profit. If that was your goal, you could just close out your option by selling it back in the marketplace instead of exercising.

You are currently short one put option on TOP at the $35 strike. TOP is currently trading at $20.00 (your option is in-the-money), and you think this dog is dropping to the floor (going lower). You want to exercise your put option and get short TOP at $35. When you exercise your option, you will get rid of your option contract and convert it into short 100 shares of TOP at $35.

Remember, most people don’t exercise their options, only 17%. Most options traders have no desire or the funds to convert their options into shares or short shares.

Now let’s discuss some rules. These rules will help us from screwing up when it comes to exercising, but like all good rules, there will be exceptions which we will discuss.

Rule #1:
Never exercise an option that is out-of-the-money. Exercising options are meant for in-the-money options only. This is easily explained with an example.

You are long a call at the 50 strike. Your underlying is currently trading at $40, and you decide to exercise. Now you have converted your option into shares at $50.00 even though the underlying is only trading at $40; you have a loss. If you wanted to get the shares of the stock, you should have closed out your option (‘Sell to Close’) and bought the shares in the market for $40 instead of $50. Don’t set yourself up by starting with a loss, only exercise in-the-money options.

Rule #2:
Never exercise an option before expiration. By exercising before expiration, you are forfeiting the properties of the option that you have already paid for.

There are two main reasons for this rule. First, you will forfeit the time value of the option. If your underlying is trading at $50 and your long a call option at the $45 strike you will have at least a $5 profit (50 – 45). If you exercise your option before expiration that is your only profit on that position. If you have time remaining before expiration your call will have a higher profit by itself. The profit on your call would be $5 + time value. As soon as you exercise you lose the time value. You could ‘Sell to Close’ the option in the market for more than $5 if it is before expiration. The closer you get to expiration the more your time value decreases until it reaches $0. At expiration, your call would be worth $5, and that is when you exercise.

The second reason you don’t exercise before expiration is because you forfeit the insurance options provide. You are long a call on the $30 strike that cost $3.00 and expires in two-weeks, and your underlying is trading for $40. You decide you’re close enough to expiration and want to exercise your call. You no longer have your option and now hold 100 shares at $30. The next day a surprise announcement is released that the company is under investigation for fraud. The stock begins to sink and at the end of the day is worth $20. You are now sitting on a $1,000 loss. If you would have held your option, it would probably be worthless now, but your total loss would have only been $300.

How Do You Exercise Your Option

Some but not all brokerages have a button on their trading platform that allows for easy exercising. A lot of brokerages still make you call in and tell them you want to exercise your option. If an option is slightly ($0.01) in-the-money it will automatically be exercised at expiration. If you have no intention or desire to exercise your options, make sure your close out your in-the-money options at expiration.

What Is Option Assignment?

Option assignment is merely the flip-side of exercising an option. When talking about exercising an option, we noted that only a buyer (long call or long put) could exercise the option. When they do decide to exercise their option a seller (short call or short put) gets assigned.

When you are short an option, call or put, you do not have the right or choice to assign the option. You have an obligation to fulfill the assignment when a buyer exercises.

So what does that mean exactly?

If you are short a call and the buyer decides to exercise (trade their option for shares) you must sell them those shares. Now if you are holding those shares in your account, as in a covered call, you would lose some of your shares, and they would get them. If you are not holding those shares in your account, as in a naked call, you would then be short those shares, and they would get them.

If you are short a put and the buyer decides to exercise (trade their option for short shares) you must buy those shares. You would now be long shares in your account instead of holding the option.

The process of matching up a buyer and a seller for exercise and assignment is done at random. The buyer’s brokerage tells the Options Clearing Corporation (“OCC”) that there is an exercise notice. The OCC will find another brokerage that matches the requirements to fulfill the exercise (same option contracts). That brokerage will then place the assignment notice to an account holder that is short those options.

You should almost never worry about being assigned when an option is out-of-the-money. It has happened in the past, but it is rare. Even though your option may not be at expiration if it is in-the-money you should be ready for assignment. An assignment is not likely but can happen before expiration. Not everyone follows our rules. Never let an in-the-money option reach expiration, it will be assigned.

How Dividends Affect Early Assignment

Remember when we talked about exceptions to our rules? Well, the exception comes in the form of a dividend.

Options don’t collect or pay out dividends. You have to hold the stock to collect dividends or short the stock to pay dividends, and you have to do this on the ex-dividend date. The ex-dividend date is the date that the company records all the shareholders so it can pay dividends to them. If you buy the stock after that, you will not receive a dividend.

If there is little time value left in our option and it is in-the-money, you can exercise the option to collect the profit and the dividend from the company.

If you are short options be aware of when a company has its ex-dividend date. You could be looking at an early assignment if you are not prepared. The most natural thing to do is just close out your in-the-money option before it gets to that date.

Conclusion

A lot of option traders get caught up in what happens to options at expiration and if they need to exercise to profit from their option. Luckily there are better solutions that don’t require you to wait such as simply closing the position out with a ‘Sell to Close’ or ‘Buy to Close’ order.

When you are long an option, you have all the power and the rights of that contract. You get to choose when to exercise. If you are short an option, you have no power and all the obligation of that contract. You do not get to decide when you are assigned.

Don’t exercise an out-of-the-money option and only exercise before expiration if there is a sizable dividend involved. If you are short options always be mindful if your option is in-the-money. You don’t want to wake up and realize you’ve been assigned so now you are either long the shares (short put) or short the shares (short call).

How do you like to close out your options? Tell us in the comments.

Understanding Options: Exercise & Assignment

As an educator in the field of options trading, I’m often asked “what causes a short call or a short put to be assigned?” Before I can answer that question I need to briefly explain what an option is, some of the terminology used, and who the participants in the exercise and assignment process are. Lastly, this discussion pertains to the American style options. These are the type of options that most of us buy and sell. They are the type of options that you would see for most equities like Apple or American Airlines. The other style of option, which we will not be covering in this discussion, is the European style option. Those options do not provide for the buying or selling of the underlying itself. They settle at expiration in cash only.

Let’s look at the basics of exercise and assignment from a theoretical perspective. In the most basic sense, options are an agreement between two parties. That agreement provides the owner of the option the right to do something. The seller of that same option is therefore obligated to fulfill the rights of the long option holder. The buyer of a long call option is purchasing the right to acquire the underlying equity for a specific price for a certain amount of time. If it is in his or her best interest financially to exercise their right than they would do so. This is known as exercising an option.

When an investor sells that same call option, they are paid a premium which is deposited into their brokerage account. At the same time, they have an open obligation to fulfill the rights of the long call option holder. If the long call option holder decides that it is in their own best interest to exercise their rights and to buy the underlying, then the short call seller would be obligated to provide the underlying to them. This is referred to as assignment.

In the case of a put option, the investor who buys a long put is purchasing the right to sell the underlying equity for a specific value for a specific amount of time. That means that if the long put holder decides that it is in their best interest to exercise their put the short put seller would be assigned and therefore have to buy the underlying equity.

Once an options contract is opened it can be exercised 24 hours a day, seven days a week. Opening or closing an option contract is quite different than exercising one. Options are opened through an exchange (like the Chicago Board of Options Exchange). They can be closed in several different ways:

1. The option can simply expire worthless at expiration
2. It can be closed by placing an order with the brokerage which is sent to one of the member exchanges
3. It can be exercised which would trigger the assignment process which would also close the option

In the first scenario above if the option is out of the money and options expiration, it would simply cease to exist and would be removed from your portfolio.

In the second scenario, you would actively send in order through your brokerage which would be routed to one of the member exchanges to close it.

The parties that are involved in the exercise and assignment process go beyond your brokerage.

In the third scenario, the long option holder is simply exercising their rights and therefore does not need an exchange. So who does the actual administrative functions to exercise and assign an option? That task would be carried out by the Options Clearing Corporation (OCC). Here’s a little bit of information about the OCC: All of the options exchanges (CBOE, Philly Exchange, Pacific exchange, etc.) are charter members of the OCC. The OCC creates the rules and bylaws that regulate and control the buying and selling of options as well as the assignment and exercise process. The member exchanges can be thought of as simply a marketplace where buyers and sellers are brought together to open a contract or to close a contract. The exchanges have no role in the actual rights and obligations of the options instrument. That process belongs to the OCC.

When a long option owner decides to exercise their rights, they would tell their broker to do so. Since we’re not talking about negotiating to open or close a contract but rather simply exercising the rights of the contract, there is no need for a marketplace or exchange so the order goes directly to the OCC. Once the OCC has the exercise order they randomly select a brokerage who is short that same option. The OCC then sends a notice of assignment to the brokerage. The brokerage in turn, selects one of their accounts at random and assigns them the obligation.

So when exactly do options get assigned? Options assignment can occur at any time once an options contract is opened. At options expiration if an option is in the money by as little as one cent, it will be exercised; with one minor caveat. That caveat is OCC rule 805D and is beyond the scope of this particular discussion. A complete list of the OCC rules can be found here: http://www.optionsclearing.com/components/docs/legal/rules_and_bylaws/occ_rules.pdf

American-style options can be exercised at any time, 24 hours a day seven days a week until they reach their expiration. So what would cause your short option to be assigned early?

It is rare that a short option that is in the money is assigned early, but it does happen occasionally. The most common cause of early assignment pertains to a short call of an equity that is about to go ex-dividend. Keep in mind that the only reason someone would exercise their long call (other than by mistake), would be if it was in their financial best interest to do so. So, in the case of a dividend paying equities, if the dividend itself is greater than the remaining extrinsic value of the in the money call option, it would make sense for the long call folder to exercise their long call, by the stock and capture the dividend. They would forfeit any remaining value in their long call. However, as I indicated above, if the dividend is greater than the remaining extrinsic value of their option, it is in their best interest to exercise their long call.

Short puts do not generally get assigned early. Keep in mind that it requires an active exercise by the long put holder to trigger the exercise and assignment process. While it can happen prior to expiration, it typically does not.

I hope that this brief explanation of the exercise and assignment process helps to clarify your understanding of how options actually work. They are contracts, legal financial contracts with performance rights and performance obligations. Please make sure that you understand your rights and your obligations before entering any trade.

Jeff McAllister
OptionsANIMAL VP of Education

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