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Option Exercise and Assignment Explained w/ Visuals
Last updated on February 11th, 2022 , 06:38 am
Buyers of options have the right to exercise their option at or before the option’s expiration. When an option is exercised, the option holder will buy (for exercised calls) or sell (for exercised puts) 100 shares of stock per contract at the option’s strike price.
Conversely, when an option is exercised, a trader who is short the option will be assigned 100 long (for short puts) or short (for short calls) shares per contract.
- Long American style options can exercise their contract at any time.
- Long calls transfer to +100 shares of stock
- Long puts transfer to -100 shares of stock
- Short calls are assigned -100 shares of stock.
- Short puts are assigned +100 shares of stock.
- Options are typically only exercised and thus assigned when extrinsic value is very low.
- Approximately only 7% of options are exercised.
The following sequences summarize exercise and assignment for calls and puts (assuming one option contract ):
Call Buyer Exercises Option ➜ Purchases 100 shares at the call’s strike price.
Call Seller Assigned ➜ Sells/shorts 100 shares at the call’s strike price.
Put Buyer Exercises Option ➜ Sells/shorts 100 shares at the put’s strike price.
Put Seller Assigned ➜ Purchases 100 shares at the put’s strike price.
Let’s look at some specific examples to drill down on this concept.
Exercise and Assignment Examples
In the following table, we’ll examine how various options convert to stock positions for the option buyer and seller:
As you can see, exercise and assignment is pretty straightforward: when an option buyer exercises their option, they purchase (calls) or sell (puts) 100 shares of stock at the strike price . A trader who is short the assigned option is obligated to fulfill the opposite position as the option exerciser.
Automatic Exercise at Expiration
Another important thing to know about exercise and assignment is that standard in-the-money equity options are automatically exercised at expiration. So, traders may end up with stock positions by letting their options expire in-the-money.
An in-the-money option is defined as any option with at least $0.01 of intrinsic value at expiration . For example, a standard equity call option with a strike price of 100 would be automatically exercised into 100 shares of stock if the stock price is at $100.01 or higher at expiration.
What if You Don't Have Enough Available Capital?
Even if you don’t have enough capital in your account, you can still be assigned or automatically exercised into a stock position. For example, if you only have $10,000 in your account but you let one 500 call expire in-the-money, you’ll be long 100 shares of a $500 stock, which is a $50,000 position. Clearly, the $10,000 in your account isn’t enough to buy $50,000 worth of stock, even on 4:1 margin.
If you find yourself in a situation like this, your brokerage firm will come knocking almost instantaneously. In fact, your brokerage firm will close the position for you if you don’t close the position quickly enough.
Why Options are Rarely Exercised
At this point, you understand the basics of exercise and assignment. Now, let’s dive a little deeper and discuss what an option buyer forfeits when they exercise their option.
When an option is exercised, the option is converted into long or short shares of stock. However, it’s important to note that the option buyer will lose the extrinsic value of the option when they exercise the option. Because of this, options with lots of extrinsic value remaining are unlikely to be exercised. Conversely, options consisting of all intrinsic value and very little extrinsic value are more likely to be exercised.
The following table demonstrates the losses from exercising an option with various amounts of extrinsic value:
As we can see here, exercising options with lots of extrinsic value is not favorable.
Why? Consider the 95 call trading for $7. Exercising the call would result in an effective purchase price of $102 because shares are bought at $95, but $7 was paid for the right to buy shares at $95.
With an effective purchase price of $102 and the stock trading for $100, exercising the option results in a loss of $2 per share, or $200 on 100 shares.
Even if the 95 call was previously purchased for less than $7, exercising an option with $2 of extrinsic value will always result in a P/L that’s $200 lower (per contract) than the current P/L. F
or example, if the trader initially purchased the 95 call for $2, their P/L with the option at $7 would be $500 per contract. However, if the trader decided to exercise the 95 call with $2 of extrinsic value, their P/L would drop to +$300 because they just gave up $200 by exercising.
7% Of Options Are Exercised
Because of the fact that traders give up money by exercising an option with extrinsic value, most options are not exercised. In fact, according to the Options Clearing Corporation, only 7% of options were exercised in 2017 . Of course, this may not factor in all brokerage firms and customer accounts, but it still demonstrates a low exercise rate from a large sample size of trading accounts.
So, in almost all cases, it’s more beneficial to sell the long option and buy or sell shares instead of exercising. We like to call this approach a “synthetic exercise.”
Congrats! You’ve learned the basics of exercise and assignment. If you’d like to know how the exercise and assignment process actually works, continue to the next section!
Who Gets Assigned When an Option is Exercised?
With thousands of traders long and short options in the market, who actually gets assigned when one of the traders exercises their option?
In this section, we’ll run through the exercise and assignment process for options so you know how the assignment decision occurs.
If a trader is short a single option, how do they get assigned if one of a thousand other traders exercises that option?
The short answer is that the process is random. For example, if there are 5,000 traders who are long a call option and 5,000 traders who are short that call option, an account with the short option will be randomly assigned the exercise notice. The random process ensures that the option assignment system is fair
Visualizing Assignment and Exercise
The following visual describes the general process of exercise and assignment:
If you’d like, you can read the OCC’s detailed assignment procedure here (warning: it’s intense!).
Now you know how the assignment procedure works. In the final section, we’ll discuss how to quickly gauge the likelihood of early assignment on short options.
Assessing Early Option Assignment Risk
The final piece of understanding exercise and assignment is gauging the risk of early assignment on a short option.
As mentioned early, only 7% of options were exercised in 2017 (according to the OCC). So, being assigned on short options is rare, but it does happen. While a specific probability of getting assigned early can’t be determined, there are scenarios in which assignment is more or less likely.
The following scenarios summarize broad generalizations of early assignment probabilities in various scenarios:
In regards to the dividend scenario, early assignment on in-the-money short calls with less extrinsic value than the dividend is more likely because the dividend payment covers the loss from the extrinsic value when exercising the option.
All in all, the risk of being assigned early on a short option is typically very low for the reasons discussed in this guide. However, it’s likely that you will be assigned on a short option at some point while trading options (unless you don’t sell options!), but at least now you’ll be prepared!
Next Lesson
Options Trading for Beginners
Intrinsic and Extrinsic Value in Options Trading Explained
Option Greeks Explained: Delta, Gamma, Theta & Vega
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Navigating exercise & assignment
Exercise & assignment: a cautionary tale
You shake your Magic 8 ball and the screen reads, “Just because you can, doesn’t always mean you should…”
Sage advice, especially when it comes to exercising your options. If you buy calls or puts and decide to do what the option gives you the right to do—buy stock for long call options or sell stock for long put options—it sets off a process called “exercise and assignment.” Normally, this isn’t the road most traders go down. Rather, most traders open options positions with the intent to close them later for a profit—un-exercised. Let’s break things down and take a closer look at the mechanics of exercise and assignment.
The mechanics of exercise & assignment
When you exercise a long call, you convert your call into stock. You’ll actually get 100 shares of the stock for every call you exercise…along with a bill for the cost of the stock, dictated by the strike of the call you’re exercising. For example, if you exercised a call with a strike price of $50, you would buy 100 shares of the underlying stock at $50 per share, for a total cost of $5,000.
Now, your exercise is someone else’s assignment . A randomly selected person who is short that call option receives a notice that they’ve been “assigned” and are required to sell 100 shares of stock for every option they’re assigned.
If we’re talking about put options, when you exercise your put, you’re selling (“putting,” actually) the stock to someone (also nameless) who is short a put on the other side of the trade. They have to buy it.
This great power to exercise is always in the control of the option owner, except at expiration. At that point, options that are in the money, even by just one cent, will be exercised automatically (this is common, but always check with your broker regarding automatic exercise policies).
The good, the bad, the ugly (of exercising)…
First, here are a few scenarios where exercising might be a good idea.
- You were assigned on the short leg of a spread . (More on this below.)
- You really, really want to buy or sell the stock, and you can afford to.
- The option you own is illiquid and the bid/ask spread (the difference between the bid and the ask) is very wide. If you stand to lose more selling the option than simply exercising, it makes sense to go ahead and exercise. You don’t want to sell an option for less than its real value (the value that’s in the money ).
- Sometimes it is worth exercising your long call to collect a dividend. Remember, options owners do not take part in collecting dividends, only stockholders.
Then, here’s why you may not want to exercise.
- Long options are cheaper than long or short stock.
- Long options are lower risk in that only the premium spent is the maximum you can lose when compared to being long or short stock. Even if you can afford the stock position, make sure you want to take on that type of risk.
- You’re simply giving away your money if your option has any time value. Rather than exercise, if you sell your option in order to close, you not only keep that time value, but you can also mitigate the loss due to an early assignment (in the case of a long option that was previously a part of a spread).
- You’re giving away even more money if you exercise an out of the money option. If an option is OTM and you don’t want it anymore, you try to sell it. If there is no value to it, you may want to just let it expire worthless. Who knows, the stock could make a comeback before expiration.
…and now for the Ugly (of Assignment)
Where new options traders can get in a lot of trouble is misunderstanding assignments—particularly when they’re trading spreads, which contain both a long and a short option. Whereas exercising is something you control in a long position, assignment is something that can happen to you at any time while you’re in a short position.
If your short put option goes in the money and you’re assigned, the cash balance in your account might show a large loss equal to the size of the assigned position. If your short call option gets assigned, you might see a short stock position resulting from selling shares you didn’t already own. But fear not! That’s where your long option comes to the rescue.
As soon as you exercise the long option from the spread, you’ll immediately offset the loss, minus the maximum loss of the spread (which is usually the distance between the short and long strikes of the options).
Closing time, time for you to go out…
If you’re speculating with options, exercising is rarely the optimal choice to close your position. However, it’s worth knowing when you should or shouldn’t and what to do when faced with the decision.
If you have a short, deep-in-the-money option and are at risk of being assigned, it’s usually best to close the position and move on prior to expiration. Assignment doesn’t happen all the time, but it’s the reason you never want to “set and forget” about your options trades, particularly spreads with short options. When your short options go in the money, the longer you remain in the position, the greater the chance you have of being assigned.
The Step-by-Step to Exercise
If you need to exercise your long options:
- Open Robinhood, and go to your positions screen by tapping the chart icon in the lower left
- Tap “Exercise,” and follow the instructions
Next up: Risk management
Disclosures
*Content is provided for informational purposes only, does not constitute tax or investment advice, and is not a recommendation for any security or trading strategy. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results. *
Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.
Robinhood Financial does not guarantee favorable investment outcomes. The past performance of a security or financial product does not guarantee future results or returns. Customers should consider their investment objectives and risks carefully before investing in options. Because of the importance of tax considerations to all options transactions, the customer considering options should consult their tax advisor as to how taxes affect the outcome of each options strategy. Supporting documentation for any claims, if applicable, will be furnished upon request.
New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock . Securities trading is offered through Robinhood Financial LLC.
The Mechanics of Option Trading, Exercise, and Assignment
Options were originally traded in the over-the-counter ( OTC ) market , where the terms of the contract were negotiated. The advantage of the OTC market over the exchanges is that the option contracts can be tailored: strike prices, expiration dates, and the number of shares can be specified to meet the needs of the option buyer. However, transaction costs are greater and liquidity is less.
Option trading really took off when the first listed option exchange — the Chicago Board Options Exchange ( CBOE )— was organized in 1973 to trade standardized contracts, greatly increasing the market and liquidity of options. The CBOE was the original exchange for options, but, by 2003, it has been superseded in size by the electronic Nasdaq International Securities Exchange (ISE), based in New York. Most options sold in Europe are traded through electronic exchanges. Other exchanges for options in the United States include: New York Stock Exchange , and the NASDAQtrader.com .
Option exchanges are central to the trading of options:
- they establish the terms of the standardized contracts
- they provide the infrastructure — both hardware and software — to facilitate trading, which is increasingly computerized
- they link together investors, brokers, and dealers on a centralized system, so that traders get the best bid/ask prices
- they guarantee trades by taking the opposite side of each transaction
- they establish the trading rules and procedures
Options are traded just like stocks — the buyer buys at the ask price and the seller sells at the bid price . The settlement time for option trades is 1 business day ( T+1 ). However, to trade options, an investor must have a brokerage account and be approved for trading options and must also receive a copy of the booklet Characteristics and Risks of Standardized Options .
The option holder, unlike the holder of the underlying stock, has no voting rights in the corporation, and is not entitled to any dividends. Brokerage commissions are still charged for options even though the commissions for stocks have been free for a while. Prices for most options range from $0.65 to $1 per contract .
The Options Clearing Corporation (OCC)
The Options Clearing Corporation ( OCC ) is the counterparty to all option trades. The OCC issues, guarantees, and clears all option trades involving its member firms, including all U.S. option exchanges, and ensures that sales are transacted according to the current rules. The OCC is jointly owned by its member firms — the exchanges that trade options — and issues all listed options, and controls and effects all exercises and assignments. To provide a liquid market, the OCC guarantees all trades by acting as the other party to all purchases and sales of options.
The OCC, like other clearing companies, is the direct participant in every purchase and sale of an option contract. When an option writer or holder sells his contracts to someone else, the OCC serves as an intermediary in the transaction. The option writer sells his contract to the OCC and the option buyer buys it from the OCC.
The OCC publishes statistics, news on options, and any notifications about changes in the trading rules, or the adjustment of certain option contracts because of a stock split or that were subjected to unusual circumstances, such as a merger of companies whose stock was the underlying security to the option contracts.
The OCC operates under the jurisdiction of both the Securities and Exchange Commission ( SEC ) and the Commodities Futures Trading Commission ( CFTC ). Under its SEC jurisdiction, OCC clears transactions for put and call options on common stocks and other equity issues, stock indexes, foreign currencies, interest rate composites and single-stock futures . As a registered Derivatives Clearing Organization ( DCO ) under CFTC jurisdiction, the OCC clears and settles transactions in futures and options on futures .
The Exercise of Options by Option Holders and the Assignment to Fulfill the Contract to Option Writers
When an option holder wants to exercise his option, he must notify his broker of the exercise, and if it is the last trading day for the option, the broker must be notified before the exercise cut-off time , which will probably be earlier than on trading days before the last day, and the cut-off time may differ for different option classes or for index options. Although policies differ among brokerages, it is the duty of the option holder to notify his broker to exercise the option before the cut-off time.
When the broker is notified, then the exercise instructions are sent to the OCC, which then assigns the exercise to one of its Clearing Members who are short in the same option series as is being exercised. The Clearing Member will then assign the exercise to one of its customers who is short in the option. The customer is selected by a specific procedure, usually on a first-in, first-out basis, or some other fair procedure approved by the exchanges. Thus, there is no direct connection between an option writer and a buyer.
To ensure contract performance, option writers are required to post margin, the amount depending on how much the option is in the money. If the margin is deemed insufficient, then the option writer will be subjected to a margin call. Option holders don't need to post margin because they will only exercise the option if it is in the money. Options, unlike stocks, cannot be bought on margin.
Because the OCC is always a party to an option transaction, an option writer can close out his position by buying the same contract back, even while the contract buyer retains his position, because the OCC draws from a pool of contracts with no connection to the original contract writer and buyer.
A diagram outlining the exercise and assignment of a call.
Example: No Direct Connection between Investors Who Write Options and those Who Buy Them
John Call-Writer writes an option that legally obligates him to provide 100 shares of JXYZ for the price of $30 until April. The OCC buys the contract, adding it to the millions of other option contracts in its pool. Sarah Call-Buyer buys a contract that has the same terms that John Call-Writer wrote — in other words, it belongs to the same option series . However, option contracts have no name on them. Sarah buys from the OCC, just as John sold to the OCC, and she just gets a contract giving her the right to buy 100 shares of JXYZ for $30 per share until April.
Scenario 1 — Exercises of Options are Assigned According to Specific Procedures
In February, the price of JXYZ rises to $35, and Sarah thinks it might go higher in the long run, but since March and April generally are volatile times for most stocks, she decides to exercise her call (sometimes called calling the stock ) to buy JXYZ stock at $30 per share to hold the stock indefinitely. She instructs her broker to exercise her call; her broker forwards the instructions to the OCC, which then assigns the exercise to one of its participating members who provided the call for sale; the participating member, in turn, assigns it to an investor who wrote such a call; in this case, it happened to be John's brother, Sam Call-Writer. John got lucky this time. Sam, unfortunately, either must turn over his appreciated shares of JXYZ, or he'll have to buy them in the open market to provide them. This is the risk that an option writer must take — an option writer never knows when he'll be assigned an exercise when the option is in the money.
Scenario 2 — Closing Out an Option Position by Buying Back the Contract
John Call-Writer decides that JXYZ might climb higher in the coming months, and so decides to close out his short position by buying a call contract with the same terms that he wrote — one that is in the same option series. Sarah, on the other hand, decides to maintain her long position by keeping her call contract until April. This can happen because there are no names on the option contracts. John closes his short position by buying the call back from the OCC at the market price, which may be higher or lower than what he paid, resulting in either a profit or a loss. Sarah can keep her contract because when she sells or exercises her contract, it will be with the OCC, not with John, and Sarah can be sure that the OCC will fulfill the terms of the contract if she exercises it later.
Thus, the OCC allows each investor to act independently of the other .
When the assigned option writer must deliver stock, she can deliver stock already owned, buy it on the market for delivery, or ask her broker to go short on the stock and deliver the borrowed shares. However, finding borrowed shares to short may not always be possible, so this method may not be available.
If the assigned call writer buys the stock in the market for delivery, the writer only needs the cash in his brokerage account to pay for the difference between what the stock cost and the strike price of the call, since the writer will immediately receive cash from the call holder for the strike price. Similarly, if the writer is using margin, then the margin requirements apply only to the difference between the purchase price and the strike price of the option. Full margin requirements, however, apply to shorted stock.
An assigned put writer will need either the cash or the margin to buy the stock at the strike price, even if he intends to sell the stock immediately after the exercise of the put. When the call holder exercises, he can keep the stock or immediately sell it. However, he must have the margin, if he has a margin account, or cash, for a cash account, to pay for the stock, even if he sells it immediately. He can also use the delivered stock to cover a short in the stock. (Note: equity requirements differ because an assigned call writer immediately receives the cash upon delivery of the shares, whereas a put writer or a call holder who purchased the shares may decide to keep the stock.)
Example: Fulfilling a Naked Call Exercise
A call writer receives an exercise notice on 10 call contracts with a strike of $30 per share on JXYZ stock on which she is still short. The stock currently trades at $35 per share. She does not own the stock, so, to fulfill her contract, she must buy 1,000 shares of stock in the market for $35,000 then sell it for $30,000, resulting in an immediate loss of $5,000 minus the commissions of the stock purchase and assignment.
Both the exercise and assignment incur brokerage commissions for both holder and assigned writer. Generally, the commission is smaller to sell the option than it is to exercise it. However, there may be no choice if it is the last day of trading before expiration. Both the buying and selling of options and the exercise or assignment are settled in 1 business day after the trade ( T+1 ).
Often, a writer will want to cover his short by buying the written option back on the open market. However, once he receives an assignment, then it is too late to cover his short position by closing the position with a purchase. Assignment is usually selected from writers still short at the end of the trading day. A possible assignment can be anticipated if the option is in the money at expiration, the option is trading at a discount, or the underlying stock is about to pay a large dividend.
The OCC automatically exercises any option that is in the money by at least $0.01 ( automatic exercise , Exercise-by-Exception , Ex-by-Ex ), unless notified by the broker not to. A customer may not want to exercise an option that is only slightly in the money if the transaction costs would exceed the net profit from the exercise. Despite the automatic exercise by the OCC, the option holder should notify his broker by the exercise cut-off time , which may be before the end of the trading day, of an intent to exercise. Exact procedures depend on the broker.
Any option that is sold on the last trading day before expiration would likely be bought by a market maker. Because a market maker's transaction costs are lower than for retail customers, a market maker may exercise an option even if it is only a few cents in the money. Thus, any option writer who does not want to be assigned should close out his position before expiration day if there is any chance that it will be in the money even by a few pennies.
Early Exercise
Sometimes, an option will be exercised before its expiration day — called early exercise , or premature exercise . Because options have a time value in addition to intrinsic value, most options are not exercised early. However, there is nothing to prevent someone from exercising an option, even if it is not profitable to do so, and sometimes it does occur, which is why anyone who is short an option should expect the possibility of being assigned early.
When an option is trading below parity (below its intrinsic value), then arbitrageurs can take advantage of the discount to profit from the difference, because their transaction costs are very low. An option with a high intrinsic value will have little time value, and so, because of the difference between supply and demand in the market at any given moment, the option could be trading for less than its true worth. An arbitrageur will almost certainly take advantage of the price discrepancy for an instant profit. Anyone who is short an option with a high intrinsic value should expect a good possibility of being assigned an exercise.
Example: Early Exercise by Arbitrageurs Profiting from an Option Discount
JXYZ stock is currently at $40 per share. Calls on the stock with a strike of $30 are selling for $9.80. This is a difference of $0.20 per share, enough of a difference for an arbitrageur, whose transaction costs are typically much lower than for a retail customer, to profit immediately by selling short the stock at $40 per share, then covering his short by exercising the call for a net of $0.20 per share minus the arbitrageur's small transaction costs.
Option discounts will only occur when the time value of the option is small, because either it is deep in the money or the option will soon expire.
Option Discounts Arising from an Imminent Dividend Payment on the Underlying Stock
When a large dividend is paid by the underlying stock, its price drops on the ex-dividend date, resulting in a lower value for the calls. The stock price may remain lower after the payment, because the dividend payment lowers the book value of the company. This causes many call holders to either exercise early to collect the dividend, or to sell the call before the drop in stock price. When many call holders sell at once, the calls sell at a discount to the underlying, creating opportunities for arbitrageurs to profit from the price difference. However, there is risk the transaction will lose money, because the dividend payment and drop in stock price may not equal the premium paid for the call, even if the dividend exceeds the time value of the call.
Example: Arbitrage Profit/Loss Scenario for a Dividend-Paying Stock
JXYZ stock is currently trading at $40 per share and will pay a dividend of $1 the next day. A call with a $30 strike is selling for $10.20, the $0.20 being the time value of the premium. So an arbitrageur decides to buy the call and exercise it to collect the dividend. Since the dividend is $1, but the time value is only $0.20, this could lead to a profit of $0.80 per share, but on the ex-dividend date, the stock drops to $39. Adding the $1 dividend to the share price yields $40, which is still less than buying the stock for $30 + $10.20 for the call. It might be profitable if the stock does not drop as much on the ex-date or it recovers after the ex-date sufficiently to make it profitable. But this is a risk for the arbitrageur, and this transaction is, thus, known as risk arbitrage , because the profit is not guaranteed.
2019 Statistics for the Fate of Options
Data Source: https://www.optionseducation.org/referencelibrary/faq/options-exercise
All option writers who didn't close out their position earlier by buying an offsetting contract made the maximum profit — the premium — on those contracts that expired. Option writers have lost at least something when the option is exercised, because the option holder wouldn't exercise it unless it was in the money. The more the exercised option was in the money, the greater the loss is for the assigned option writer and the greater the profits for the option holder. A closed out transaction could be at a profit or a loss for both holders and writers of options, but closing out a transaction is usually done either to maximize profits or to minimize losses, based on expected changes in the price of the underlying security until expiration.
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The Risks of Options Assignment
Any trader holding a short option position should understand the risks of early assignment. An early assignment occurs when a trader is forced to buy or sell stock when the short option is exercised by the long option holder. Understanding how assignment works can help a trader take steps to reduce their potential losses.
Understanding the basics of assignment
An option gives the owner the right but not the obligation to buy or sell stock at a set price. An assignment forces the short options seller to take action. Here are the main actions that can result from an assignment notice:
- Short call assignment: The option seller must sell shares of the underlying stock at the strike price.
- Short put assignment: The option seller must buy shares of the underlying stock at the strike price.
For traders with long options positions, it's possible to choose to exercise the option, buying or selling according to the contract before it expires. With a long call exercise, shares of the underlying stock are bought at the strike price while a long put exercise results in selling shares of the underlying stock at the strike price.
When a trader might get assigned
There are two components to the price of an option: intrinsic 1 and extrinsic 2 value. In the case of exercising an in-the-money 3 (ITM) long call, a trader would buy the stock at the strike price, which is lower than its prevailing price. In the case of a long put that isn't being used as a hedge for a long stock position, the trader shorts the stock for a price higher than its prevailing price. A trader only captures an ITM option's intrinsic value if they sell the stock (after exercising a long call) or buy the stock (after exercising a long put) immediately upon exercise.
Without taking these actions, a trader takes on the risks associated with holding a long or short stock position. The question of whether a short option might be assigned depends on if there's a perceived benefit to a trader exercising a long option that another trader has short. One way to attempt to gauge if an option could be potentially assigned is to consider the associated dividend. An options seller might be more likely to get assigned on a short call for an upcoming ex-dividend if its time value is less than the dividend. It's more likely to get assigned holding a short put if the time value has mostly decayed or if the put is deep ITM and close to expiration with a wide bid/ask spread on the stock.
It's possible to view this information on the Trade page of the thinkorswim ® trading platform. Review past dividends, the price of the short call, and the price of the put at the call's strike price. While past performance cannot be relied upon to continue, this information can help a trader determine whether assignment is more or less likely.
Reducing the risk associated with assignment
If a trader has a covered call that's ITM and it's assigned, the trader will deliver the long stock out of their account to cover the assignment.
A trader with a call vertical spread 4 where both options are ITM and the ex-dividend date is approaching may want to exercise the long option component before the ex-dividend date to have long stock to deliver against the potential assignment of the short call. The trader could also close the ITM call vertical spread before the ex-dividend date. It might be cheaper to pay the fees to close the trade.
Another scenario is a call vertical spread where the ITM option is short and the out-of-the-money (OTM) option is long. In this case, the trader may consider closing the position or rolling it to a further expiration before the ex-dividend date. This move can possibly help the trader avoid having short stock on the ex-dividend date and being liable for the dividend.
Depending on the situation, a trader long an ITM call might decide it's better to close the trade ahead of the ex-dividend date. On the ex-dividend date, the price of the stock drops by the amount of the dividend. The drop in the stock price offsets what a trader would've earned on the dividend and there would still be fees on top of the price of the put.
Assess the risk
When an option is converted to stock through exercise or assignment, the position's risk profile changes. This change could increase the margin requirements, or subject a trader to a margin call, 5 or both. This can happen at or before expiration during early assignment. The exercise of a long option position can be more likely to trigger a margin call since naked short option trades typically carry substantial margin requirements.
Even with early exercise, a trader can still be assigned on a short option any time prior to the option's expiration.
1 The intrinsic value of an options contract is determined based on whether it's in the money if it were to be exercised immediately. It is a measure of the strike price as compared to the underlying security's market price. For a call option, the strike price should be lower than the underlying's market price to have intrinsic value. For a put option the strike price should be higher than underlying's market price to have intrinsic value.
2 The extrinsic value of an options contract is determined by factors other than the price of the underlying security, such as the dividend rate of the underlying, time remaining on the contract, and the volatility of the underlying. Sometimes it's referred to as the time value or premium value.
3 Describes an option with intrinsic value (not just time value). A call option is in the money (ITM) if the underlying asset's price is above the strike price. A put option is ITM if the underlying asset's price is below the strike price. For calls, it's any strike lower than the price of the underlying asset. For puts, it's any strike that's higher.
4 The simultaneous purchase of one call option and sale of another call option at a different strike price, in the same underlying, in the same expiration month.
5 A margin call is issued when the account value drops below the maintenance requirements on a security or securities due to a drop in the market value of a security or when buying power is exceeded. Margin calls may be met by depositing funds, selling stock, or depositing securities. A broker may forcibly liquidate all or part of the account without prior notice, regardless of intent to satisfy a margin call, in the interests of both parties.
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Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any options transaction. Supporting documentation for any claims or statistical information is available upon request.
With long options, investors may lose 100% of funds invested.
Spread trading must be done in a margin account.
Multiple leg options strategies will involve multiple commissions.
Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Exercising Options
The holder of an american-style option can exercise his right to buy (in the case of a call) or to sell (in the case of a put) the underlying shares of stock. .
They first must direct their brokerage firm to submit an exercise notice to OCC. For an option holder to ensure that they exercise the option on that particular day, the holder must notify his brokerage firm before that day’s cut-off time for accepting exercise instructions.
The brokerage firm notifies OCC that an option holder wishes to exercise an option. OCC then randomly assigns the exercise notice to a clearing member. For an investor, this is generally his brokerage firm chosen at random from a total pool of such firms. The firm must then assign one of its customers who has written (and not covered) that particular option.
Assignment to a customer is either random or on a first-in-first-out basis. This depends on the firm’s method. Ask your brokerage firm which method it uses for assignments.
The holder of an American-style option contract can exercise the option at any time before expiration. Therefore, an option writer may be assigned an exercise notice on a short option position at any time before expiration. If an option writer is short an option that expires in-the-money, they should expect assignment on that contract, though assignment is not guaranteed as some long in-the-money option holders may elect not to exercise in-the-money options. In fact, some option writers are assigned on short contracts when they expire exactly at-the-money or even out-of-the money. This occurrence is usually not predictable.
To avoid assignment on a written option contract on a given day, the position must be closed out before that day's market close. Once assignment is received, an investor has no alternative but to fulfill assignment obligations per the terms of the contract.
There is generally no exercise or assignment activity on options that expire out-of-the-money. Owners usually let them expire with no value. Although this is not always the case as post-market underlying moves may lead to out-of-the-money options being exercised and in-the-money options not being exercised.
READ MORE ON ASSIGNMENT (PDF)
What's the Net?
When an investor exercises a call option, the net price paid for the underlying stock on a per share basis is the sum of the call's strike price plus the premium paid for the call. Likewise, when an investor who has written a call contract is assigned an exercise notice on that call, the net price received on per share basis is the sum of the call's strike price plus the premium received from the call's initial sale.
When an investor exercises a put option, the net price received for the underlying stock on per share basis is the sum of the put's strike price less the premium paid for the put. Likewise, when an investor who has written a put contract is assigned an exercise notice on that put, the net price paid for the underlying stock on per share basis is the sum of the put's strike price less the premium received from the put's initial sale.
Early Exercise/Assignment
For call contracts, owners might exercise early to own the underlying stock to receive a dividend. Check with your brokerage firm on the advisability of early call exercise.
It is extremely important to realize that assignment of exercise notices can occur early, days or weeks in advance of expiration day. Investors should expect this as expiration nears with a call considerably in-the-money and a sizeable dividend payment approaching. Call writers should be aware of dividend dates and the possibility of early assignment.
When puts become deep in-the-money, most professional option traders exercise before expiration. Therefore, investors with short positions in deep in-the-money puts should be prepared for the possibility of early assignment on these contracts.
Volatility is the tendency of the underlying security's market price to fluctuate up or down. It reflects a price change's magnitude. It does not imply a bias toward price movement in one direction or the other. It is a major factor in determining an option's premium.
The higher the volatility of the underlying stock, the higher the premium. This is because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an underlying stock increases, the premiums of both calls and puts overlying that stock increase and vice versa.
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Exercise & Assignement - A Guide
Exercise & Assignment: There are many questions asked over and over with exercise and assignment being among the most common and repetitive. I was asked to put together a guide that can hopefully be used to answer many of these so here it is!
Buyer and Seller Definitions:
- Option Buyer: Purchases the option from the option writer/seller and pays them a premium. The buyer has the right to exercise the option at any time and assign stock to the seller that they are obligated to buy or sell (based on the type of option) at the strike price. The buyer profits from the option price going up.
- Option Writer/Seller: Writes and sells the option to the buyer and collects the premium. The seller has the obligation to take an assignment of the stock at the strike price if the buyer exercises the option. The seller profits if the option price goes down.
Buyer FAQs: (Seller FAQ below)
Q1: As the option buyer do I have to exercise to collect the profit?
A1: No! Any option can be closed to immediately collect any profit and save the cost, plus the risk and time of the exercise process. Exercising early will forgo any extrinsic value that could be captured by just closing the option and is another disadvantage of exercising.
Q2: If I Sell to Close am I under any obligation to be assigned stock should the option be exercised in the future?
A2: No! Once an option is closed there is no longer any rights or obligations regardless of what any future trader does with that option.
Q3: As the buyer, I thought I had no risk of being assigned stock, but after my long option expired I got assigned. How did this happen?
A3: Your option was ITM when it expired, and standard broker policy is to exercise any long option that is .01 or more ITM. This means your option was profitable and the broker exercised it to protect that profit which resulted in stock being assigned. To prevent this from happening simply close the option and collect the profit prior to it expiring. The position should still be at a profit so the stock can be sold (or bought) to collect it.
Q4: When would I want to exercise an option vs. just closing it?
A4: There are very few occasions when exercising makes more sense than closing, but one is if you want to own the stock at the strike price. Because exercising is costly, adds risk and time it is usually better to close the option to collect the profit and then use that profit to help buy the stock outright. On a rare occasion, you can exercise a long leg to cover a short leg assignment.
Q5: Should I be concerned with the short leg of my Debit spread being assigned?
A5: No, if the short leg gets assigned this means the long leg is well ITM and profitable. Just close the long leg to collect the profit and then close the stock position, or exercise the long leg to cover the assignment but remember the costs, risks and time of exercising can cause unnecessary losses.
Seller FAQs:
Q6: Can my short option be assigned early? If so, how often does this happen?
A6: Yes! The option buyer can exercise at any time, but the odds of this are very low. Data varies over time, but over 70% of options are closed with 25% expiring worthless and only about 5% of all options being exercised. Of that 5% there are many traders whose strategy is to be assigned and then a lot more where the option is exercised at expiration, so the amount of options assigned early is a very small percentage.
Q7: How do I know if I am in danger of being assigned early?
A7: There is no way to tell with certainty if you will be assigned, but the farther ITM and the closer the option gets to expiration the odds go up. If you have an option that is well ITM and expiring in a week or less, then closing or rolling it would be advised if you do not wish to be assigned.
Q8: What is short call dividend risk?
A8: Short call options have a dividend assignment risk on the day prior to the stocks ex-dividend date and this video will help understand the risk - https://optionalpha.com/members/knowledge-base#13 If your call option is at risk either close or roll it to avoid being assigned and be aware you could be responsible to pay the option buyer the dividend even if you don't collect it.
Q9: What happens if I am assigned and don't have the money to pay for the stock?
A9: Most full-service brokers will issue a "margin call" to you indicating you have exceeded your account balance and then give you 2 or 3 days to bring your account balance back to even or above. Usually just closing out the stock position will bring the account back to a positive balance, but adding cash will do so as well. If you do not close the stock position or add cash then the broker will liquidate this or other positions as needed. Being assigned without having the cash is really not a big deal and communicating with your broker on your plan will go a long way with them to work with you for the best possible result. However, if you do this routinely the broker may reduce your options trading level or close your account.
Q10: I was assigned stock, what can I do?
A10: You can just buy or sell to close the stock position and take about the same loss as the option position was in. If you can afford to hold the long stock or short stock then selling covered calls or covered puts accordingly can help bring in more premium to possibly break even or profit over time.
Q11: Can the short leg of a credit spread be assigned? If so, won't the broker just exercise the long leg to cover it?
A11: Yes, any short option can be assigned at any time the buyer exercises it. If this happens you can close the long leg that has usually gone up in value to help the P&L, and the result is usually around the same max loss of the spread when opened. If the short leg is ITM, or very close, but the long leg is not, then there is a chance the short leg will be assigned and the long leg will expire worthless perhaps causing a larger loss. Closing the short leg or position will take off any risk, or it can be rolled to reduce the risk. No, the broker will not usually exercise your long option early, and will only exercise it if it is .01 or more ITM at expiration as noted in Q3 above. It is up to you to manage your trades and you should not expect the broker to do that for you, even if it seems obvious.
Resources on Exercise & Assignment:
- OIC Options Assignment FAQs - https://www.optionseducation.org/referencelibrary/faq/options-assignment
- CBOE Quick Facts - http://www.cboe.com/education/getting-started/quick-facts/expiration-exercise-assignment
- OA Options Assignment process - https://optionalpha.com/members/video-tutorials/options-expiration/options-assignment-process
- TT Assignment - https://www.tastytrade.com/tt/learn/assignment
Edited for formatting and additional detail.
Please feel free to add to this list with any questions not covered above! -Scot out!
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Exercising Options
Submitting exercise or do-not-exercise instructions:.
- All Instructions must be called in and are only applicable to long positions
- Do-Not-Exercise instructions can only be submitted the day of expiration up through market close
- Exercise instructions can be submitted at any time until expiration
- Merrill may take action at any time to close out positions that may not be able to be supported if exercised/assigned. It is extremely important to monitor your open options positions and be aware of your risk exposure.
What's the Net?
Automatic exercise/ assignment, early exercise/assignment, without the jargon, what are options, what are the types of options, what are the greeks, similar articles, options pricing, equity option basics, equity index options.
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What is an Assignment in Options?
How does assignment work, what does “write an option” mean, how do you know if an option position will be assigned, what happens after an option is assigned, short put vs. short call, option assignment examples, option assignment summed up, supplemental content, what is an option assignment & how does it work.
Options assignment refers to the process in which the obligations of an options contract are fulfilled. This happens when the holder of an options contract decides to exercise their rights.
When an option holder decides to exercise, the Options Clearing Corporation (OCC) will randomly assign the exercise notice to one of the option writers.
A call option gives the holder the right to buy an underlying asset at a specified price (the strike price) within a certain period. If the holder decides to exercise a call option, the seller (writer) of the option is obligated to sell the underlying asset at the strike price. In this case, the option seller is said to be "assigned."
A put option gives the holder the right to sell an underlying asset at a specified price within a certain period. If the holder decides to exercise a put option, the seller of the option is obligated to buy the underlying asset at the strike price. Again, the option seller is "assigned" in this scenario.
Importantly, being assigned on an option can lead to significant financial obligations, particularly if the option writer does not already own the underlying asset for a call option (known as a naked call) or does not have the cash to buy the underlying asset for a put option. Therefore, option writers should be prepared for the possibility of assignment.
Options assignment works in tandem with the exercise of an options contract. It's the process of fulfilling the obligations of the options contract when the option holder decides to exercise their contractual right as outlined above.
When an option owner exercises their right to convert the option to stock, the option writer is assigned and the option is converted to 100 shares of stock per option contract. Simply put, assignment refers to an options contract being converted to 100 shares of stock, regardless of whether it is a naked option or part of a multi-leg options strategy.
Long call options convert to 100 shares of long stock, and short call options convert to 100 shares of short stock at the strike price.
Long put option contracts convert to 100 shares of short stock, and short put option contracts convert to 100 shares of long stock at the strike price.
In general, the options assignment process includes four steps, as outlined below:
Option Exercise : The holder of the option (the investor who purchased the option) decides to exercise the option. This decision is typically made when it is beneficial for the option holder to do so. For example, if the market price of the underlying asset is favorable compared to the strike price in the option contract.
Notification : When the option is exercised, the Options Clearing Corporation (OCC) is notified. The OCC then selects a member brokerage firm, which in turn chooses one of its clients who has written (sold) an options contract of the same series (same underlying asset, strike price, and expiration date) to be assigned.
Assignment : The selected option writer (the investor who sold the option) is then assigned by the brokerage. The assignment means that the option writer now has the obligation to fulfill the terms of the options contract.
Fulfillment : If it was a call option that was exercised, the assigned writer must sell the underlying asset to the option holder at the agreed-upon strike price. If it was a put option that was exercised, the assigned writer must buy the underlying asset from the option holder at the strike price.
It's important to note that assignment cannot happen when the market is open - these transactions take place when the options market is closed.
Writing an option refers to the act of selling an options contract.
This term is used because the seller is essentially creating (or "writing") a new contract that gives the buyer the right, but not the obligation, to buy or sell a security at a predetermined price within a specific period. In this case, "writing a put or call" and "shorting a put or call" refers to the same thing.
There are two types of options that investors/traders can write: a call option or a put option. Further details for each are outlined below:
Writing a Call Option : This process involves selling someone the right to buy a security from you at a specified price (the strike price) before the option expires. If the buyer decides to exercise their right, you, as the writer, must sell them the security at that strike price, regardless of the market price. If you don't own the underlying security, this is known as writing a naked call, which can involve substantial risk as there is no cap to how high a stock price can go. A short call holder assumes the risk of 100 shares of short stock above the strike price.
Writing a Put Option : This process involves selling someone the right to sell a security to you at a specified price before the option expires. If the buyer decides to exercise their right, you, as the writer, must buy the security from them at that strike price, regardless of the market price. A short put holder assumes the risk of 100 shares of long stock below the strike price.
When an investor/trader writes an option, he/she receives the option’s extrinsic value premium associated with assuming the intrinsic value risk of the options contract. This extrinsic value premium is theirs to keep if held through expiration, regardless of whether the option is exercised or expires worthless.
As such, writing options (i.e. selling options) is typically reserved for experienced investors/traders who are comfortable with the risks involved, as short options assume the risk of 100 shares of long or short stock depending on the options type.
It’s impossible to know for certain if a given option will be assigned, but the more extrinsic value there is associated with an option, the less likely it is to be assigned (excluding dividend risk associated with ITM short call options).
There are several situations in which an options assignment becomes more likely, as detailed below:
In-the-money (ITM) Options : An option is more likely to be exercised, and therefore assigned, if it's in the money . That means the market price of the underlying asset is above the strike price for a call option, or below the strike price for a put option. This is because exercising the option in such a scenario could start to make sense for the option owner as the option would have intrinsic value. OTM options are not likely to be assigned as the trader or investor could just buy or sell shares of stock at a better price in the outright market.
Near Expiration : Options are also more likely to be exercised as they approach their expiration date, particularly if they are in the money. This is because the extrinsic value of the option (a component of its price) diminishes as the option nears expiration, leaving only the intrinsic value (the difference between the market price of the underlying asset and the strike price).
Dividend Payments : For ITM call options, if the underlying security is due to pay a dividend, and the amount of the dividend is larger than the extrinsic value remaining in the option's price, it might make sense for the holder to exercise the option early to capture the dividend. This could lead to early assignment for the writer of the option.
Remember, even if the above scenarios exist, it does not guarantee assignment, as the option holder might not choose to exercise the option. The decision to exercise is entirely up to the option holder.
Therefore, when writing (i.e. selling) options, investors and traders should be prepared for the possibility of assignment at any time until the option expires.
Remember, as the writer of the option, you receive and keep the premium regardless of whether the option is exercised or not. But this premium may not be sufficient to offset any loss from the assignment. That's why writing options involves risk and requires careful consideration.
This term is used because the seller is essentially creating (or "writing") a new contract that gives the buyer the right, but not the obligation, to buy or sell a security at a predetermined price within a specific period.
Writing a Call Option : This process involves selling someone the right to buy a security from you at a specified price (the strike price) before the option expires. If the buyer decides to exercise their right, you, as the writer, must sell them the security at that strike price, regardless of the market price. If you don't own the underlying security, this is known as writing a naked call, which can involve substantial risk.
Writing a Put Option : This process involves selling someone the right to sell a security to you at a specified price before the option expires. If the buyer decides to exercise their right, you, as the writer, must buy the security from them at that strike price, regardless of the market price.
1. Call Option Assignment:
Imagine a scenario in which you've written (sold) a call option for ABC stock. The call option has a strike price of $60 and the expiration date is in one month. For selling this option, you've received a premium of $5.
Now, let's say the stock price of ABC stock shoots up to $70 before the expiration date. The option holder can choose to exercise the option since it is now "in-the-money" (the current stock price is higher than the strike price). If the option holder decides to exercise their right, you, as the writer, are then assigned.
Being assigned means you have to sell ABC shares to the option holder for the strike price of $60, even though the current market price is $70. If you already own the ABC shares, then you simply deliver them. If you don't own them, you must buy the shares at the current market price ($70) and sell them at the strike price ($60), incurring a loss.
2. Put Option Assignment:
Suppose you've written a put option for XYZ stock. The put option has a strike price of $50 and expires in one month. You receive a premium of $5 for writing this option.
Now, if the stock price of XYZ stock drops to $40 before the option's expiration date, the option holder may choose to exercise the option since it's "in-the-money" (the current stock price is lower than the strike price). If the holder exercises the option, you, as the writer, are assigned.
Being assigned in this scenario means you have to buy XYZ shares from the option holder at the strike price of $50, even though the current market price is $40. This means you pay more for the stock than its current market value, incurring a loss.
As such, writing options (i.e. selling options) is typically reserved for experienced investors/traders who are comfortable with the risks involved.
What does an option assignment mean?
What happens when a call is assigned.
If it was a call option that was exercised, the assigned writer must sell the underlying asset to the option holder at the agreed-upon strike price.
What happens when a short option is assigned?
How often do options get assigned.
The frequency with which options get assigned can vary significantly, depending on a number of factors. These can include the type of option, its moneyness (whether it's in, at, or out of the money), time to expiration, volatility of the underlying asset, and dividends.
According to FINRA , only about 7% of options positions are typically exercised. But that does not imply that investors can expect to be assigned on only 7% of their short positions. Investors may have some, all, or none of their short options positions assigned.
How often do options get assigned early?
According to FINRA , only 7% of all options are exercised, which indicates that early assignment options constitute an even lower percentage of the total than 7%.
How late can options be assigned?
In most cases, options can be exercised (and thus assigned to the writer) at any time up to the expiration date for American style options. However, the exact timing can depend on the rules of the specific exchange where the option is traded.
Typically, the holder of an American style option has until the close of business on the expiration date to decide whether to exercise it. Once the decision is made and the exercise notice is submitted, the Options Clearing Corporation (OCC) randomly assigns the exercise notice to one of the member brokerage firms with clients who have written (sold) options in the same series. The brokerage firm then assigns one of its clients.
Do I keep the premium if I get assigned?
As the writer of the option, you receive and keep the premium regardless of whether the option is exercised or not. But this premium may not be sufficient to offset any loss from the assignment. That's why writing options involves risk and requires careful consideration.
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Options Exercise, Assignment, and More: A Beginner's Guide
So your trading account has gotten options approval, and you recently made that first trade—say, a long call in XYZ with a strike price of $105. Then expiration day approaches and, at the time, XYZ is trading at $105.30.
Wait. The stock's above the strike. Is that in the money 1 (ITM) or out of the money 2 (OTM)? Do I need to do something? Do I have enough money in my account? Help!
Don't be that trader. The time to learn the mechanics of options expiration is before you make your first trade.
Here's a guide to help you navigate options exercise 3 and assignment 4 —along with a few other basics.
In the money or out of the money?
The buyer ("owner") of an option has the right, but not the obligation, to exercise the option on or before expiration. A call option 5 gives the owner the right to buy the underlying security; a put option 6 gives the owner the right to sell the underlying security.
Conversely, when you sell an option, you may be assigned—at any time regardless of the ITM amount—if the option owner chooses to exercise. The option seller has no control over assignment and no certainty as to when it could happen. Once the assignment notice is delivered, it's too late to close the position and the option seller must fulfill the terms of the options contract:
- A long call exercise results in buying the underlying stock at the strike price.
- A short call assignment results in selling the underlying stock at the strike price.
- A long put exercise results in selling the underlying stock at the strike price.
- A short put assignment results in buying the underlying stock at the strike price.
An option will likely be exercised if it's in the option owner's best interest to do so, meaning it's optimal to take or to close a position in the underlying security at the strike price rather than at the current market price. After the market close on expiration day, ITM options may be automatically exercised, whereas OTM options are not and typically expire worthless (often referred to as being "abandoned"). The table below spells it out.
- If the underlying stock price is...
- ...higher than the strike price
- ...lower than the strike price
- If the underlying stock price is... A long call is...
- ...higher than the strike price ...ITM and typically exercised
- ...lower than the strike price ...OTM and typically abandoned
- If the underlying stock price is... A short call is...
- ...higher than the strike price ...ITM and typically assigned
- If the underlying stock price is... A long put is...
- ...higher than the strike price ...OTM and typically abandoned
- ...lower than the strike price ...ITM and typically exercised
- If the underlying stock price is... A short put is...
- ...lower than the strike price ...ITM and typically assigned
The guidelines in the table assume a position is held all the way through expiration. Of course, you typically don't need to do that. And in many cases, the usual strategy is to close out a position ahead of the expiration date. We'll revisit the close-or-hold decision in the next section and look at ways to do that. But assuming you do carry the options position until the end, there are a few things you need to consider:
- Know your specs . Each standard equity options contract controls 100 shares of the underlying stock. That's pretty straightforward. Non-standard options may have different deliverables. Non-standard options can represent a different number of shares, shares of more than one company stock, or underlying shares and cash. Other products—such as index options or options on futures—have different contract specs.
- Stock and options positions will match and close . Suppose you're long 300 shares of XYZ and short one ITM call that's assigned. Because the call is deliverable into 100 shares, you'll be left with 200 shares of XYZ if the option is assigned, plus the cash from selling 100 shares at the strike price.
- It's automatic, for the most part . If an option is ITM by as little as $0.01 at expiration, it will automatically be exercised for the buyer and assigned to a seller. However, there's something called a do not exercise (DNE) request that a long option holder can submit if they want to abandon an option. In such a case, it's possible that a short ITM position might not be assigned. For more, see the note below on pin risk 7 ?
- You'd better have enough cash . If an option on XYZ is exercised or assigned and you are "uncovered" (you don't have an existing long or short position in the underlying security), a long or short position in the underlying stock will replace the options. A long call or short put will result in a long position in XYZ; a short call or long put will result in a short position in XYZ. For long stock positions, you need to have enough cash to cover the purchase or else you'll be issued a margin 8 call, which you must meet by adding funds to your account. But that timeline may be short, and the broker, at its discretion, has the right to liquidate positions in your account to meet a margin call 9 . If exercise or assignment involves taking a short stock position, you need a margin account and sufficient funds in the account to cover the margin requirement.
- Short equity positions are risky business . An uncovered short call or long put, if assigned or exercised, will result in a short stock position. If you're short a stock, you have potentially unlimited risk because there's theoretically no limit to the potential price increase of the underlying stock. There's also no guarantee the brokerage firm can continue to maintain that short position for an unlimited time period. So, if you're a newbie, it's generally inadvisable to carry an options position into expiration if there's a chance you might end up with a short stock position.
A note on pin risk : It's not common, but occasionally a stock settles right on a strike price at expiration. So, if you were short the 105-strike calls and XYZ settled at exactly $105, there would be no automatic assignment, but depending on the actions taken by the option holder, you may or may not be assigned—and you may not be able to trade out of any unwanted positions until the next business day.
But it goes beyond the exact price issue. What if an option is ITM as of the market close, but news comes out after the close (but before the exercise decision deadline) that sends the stock price up or down through the strike price? Remember: The owner of the option could submit a DNE request.
The uncertainty and potential exposure when a stock price and the strike price are the same at expiration is called pin risk. The best way to avoid it is to close the position before expiration.
The decision tree: How to approach expiration
As expiration approaches, you have three choices. Depending on the circumstances—and your objectives and risk tolerance—any of these might be the best decision for you.
1. Let the chips fall where they may. Some positions may not require as much maintenance. An options position that's deeply OTM will likely go away on its own, but occasionally an option that's been left for dead springs back to life. If it's a long option, the unexpected turn of events might feel like a windfall; if it's a short option that could've been closed out for a penny or two, you might be kicking yourself for not doing so.
Conversely, you might have a covered call (a short call against long stock), and the strike price was your exit target. For example, if you bought XYZ at $100 and sold the 110-strike call against it, and XYZ rallies to $113, you might be content selling the stock at the $110 strike price to monetize the $10 profit (plus the premium you took in when you sold the call but minus any transaction fees). In that case, you can let assignment happen. But remember, assignment is likely in this scenario, but it is not guaranteed.
2. Close it out . If you've met your objectives for a trade, then it might be time to close it out. Otherwise, you might be exposed to risks that aren't commensurate with any added return potential (like the short option that could've been closed out for next to nothing, then suddenly came back into play). Keep in mind, there is no guarantee that there will be an active market for an options contract, so it is possible to end up stuck and unable to close an options position.
The close-it-out category also includes ITM options that could result in an unwanted long or short stock position or the calling away of a stock you didn't want to part with. And remember to watch the dividend calendar. If you're short a call option near the ex-dividend date of a stock, the position might be a candidate for early exercise. If so, you may want to consider getting out of the option position well in advance—perhaps a week or more.
3. Roll it to something else . Rolling, which is essentially two trades executed as a spread, is the third choice. One leg closes out the existing option; the other leg initiates a new position. For example, suppose you're short a covered call on XYZ at the July 105 strike, the stock is at $103, and the call's about to expire. You could attempt to roll it to the August 105 strike. Or, if your strategy is to sell a call that's $5 OTM, you might roll to the August 108 call. Keep in mind that rolling strategies include multiple contract fees, which may impact any potential return.
The bottom line on options expiration
You don't enter an intersection and then check to see if it's clear. You don't jump out of an airplane and then test the rip cord. So do yourself a favor. Get comfortable with the mechanics of options expiration before making your first trade.
1 Describes an option with intrinsic value (not just time value). A call option is in the money (ITM) if the stock price is above the strike price. A put option is ITM if the stock price is below the strike price. For calls, it's any strike lower than the price of the underlying equity. For puts, it's any strike that's higher.
2 Describes an option with no intrinsic value. A call option is out of the money (OTM) if its strike price is above the price of the underlying stock. A put option is OTM if its strike price is below the price of the underlying stock.
3 An options contract gives the owner the right but not the obligation to buy (in the case of a call) or sell (in the case of a put) the underlying security at the strike price, on or before the option's expiration date. When the owner claims the right (i.e. takes a long or short position in the underlying security) that's known as exercising the option.
4 Assignment happens when someone who is short a call or put is forced to sell (in the case of the call) or buy (in the case of a put) the underlying stock. For every option trade there is a buyer and a seller; in other words, for anyone short an option, there is someone out there on the long side who could exercise.
5 A call option gives the owner the right, but not the obligation, to buy shares of stock or other underlying asset at the options contract's strike price within a specific time period. The seller of the call is obligated to deliver, or sell, the underlying stock at the strike price if the owner of the call exercises the option.
6 Gives the owner the right, but not the obligation, to sell shares of stock or other underlying assets at the options contract's strike price within a specific time period. The put seller is obligated to purchase the underlying security at the strike price if the owner of the put exercises the option.
7 When the stock settles right at the strike price at expiration.
8 Margin is borrowed money that's used to buy stocks or other securities. In margin trading, a brokerage firm lends an account owner a portion of the purchase price (typically 30% to 50% of the total price). The loan in the margin account is collateralized by the stock, and if the value of the stock drops below a certain level, the owner will be asked to deposit marginable securities and/or cash into the account or to sell/close out security positions in the account.
9 A margin call is issued when your account value drops below the maintenance requirements on a security or securities due to a drop in the market value of a security or when a customer exceeds their buying power. Margin calls may be met by depositing funds, selling stock, or depositing securities. Charles Schwab may forcibly liquidate all or part of your account without prior notice, regardless of your intent to satisfy a margin call, in the interests of both parties.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the Options Disclosure Document titled " Characteristics and Risks of Standardized Options " before considering any options transaction. Supporting documentation for any claims or statistical information is available upon request.
With long options, investors may lose 100% of funds invested. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received.
Short options can be assigned at any time up to expiration regardless of the in-the-money amount.
Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.
Commissions, taxes, and transaction costs are not included in this discussion but can affect final outcomes and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Short selling is an advanced trading strategy involving potentially unlimited risks and must be done in a margin account. Margin trading increases your level of market risk. For more information, please refer to your account agreement and the Margin Risk Disclosure Statement.
How Does Options Exercise & Assignment Work?
Exercise and assignment.
When a stock option is exercised, the call holder buys the stock, and the put holder sells stock. When options are exercised, the OCC decides to which brokerage firm, such as TastyWorks , the exercise will be assigned, and the brokerage in turn decides which customer will get the assignment.
When we are assigned an exercise and are required to sell our shares, the shares sold are said to have been called out or called away . Assignment occurs, then the shares are called out. Assignment on a short put means purchasing the stock.
Assignment is completely random, and an exercise can be assigned to and apportioned among several different call writers. Once assignment by OCC occurs, settlement between the buying and selling parties is automatic. Shares must be physically delivered once exercise occurs.
The covered call writer doesn’t have to do anything; the call writer’s broker handles settlement, delivers the shares and collects the exercise funds. Option exercise or assignment can be partial: one can exercise less than all the options held. Conversely, you may be assigned on less than all your short calls or puts.
However, one cannot exercise or be assigned on part of a single option contract . If you buy a call (put), you are not required to buy (sell) the underlying stock; you may sell the option to close or allow it to expire worthless.
Automatic Exercise
The OCC automatically exercises options that are $0.01 or more ITM, unless the option holder has notified his/her broker not to allow exercise of the option.
Note that a stock’s price can tick up or down after the close on expiration Friday, resulting in calls or puts (but not both calls and puts, obviously) that were near the money at Friday’s close becoming in the money – and being exercised.
If you are long calls on expiration Friday, you could find yourself purchasing shares unexpectedly, due to a late-day or after-market tick up in the stock.
Or if instead long the puts then, you might find yourself selling shares unexpectedly; and if you don’t own the underlying shares, this would either create a short stock position in your account, or your broker would buy you in (purchase the shares on your behalf) in order to cover itself.
Be sure your broker knows your wishes if you are long options at expiration and have not closed them. Writers of short calls and puts can similarly find themselves assigned an exercise due to the same mechanism.
Early Exercise
Because stock options are American-style, you can be assigned an exercise any time an option is in the money, although options typically are not exercised early while there is still time value remaining.
The reason is that the exercise of an option forfeits its time value; to capture the time value it is necessary to flip (sell) the option. But as expiration draws near, options that are in the money sometimes trade at parity, and this is when early exercise occurs.
Options trading below parity practically beg arbitrageurs to exercise them for risk-less profit. This subject is covered in more detail in the chapter on Portfolio Writing.
Where Stock Options Go:
60% – are traded out (sold or bought to close)
30% – expire worthless
10% – are exercised
Source: Chicago Board Options Exchange (CBOE)
Option traders like to say that only 10% of options are exercised, which is generally true, though not true in all cases. Thus if you write a call, the odds against assignment are roughly 9:1, statistically speaking.
But if a call is written ITM, the odds are quite high it will be exercised, despite the overall 9:1 odds. No matter where written originally, if the calls are in the money (ITM) $0.01 or more at expiration, exercise is a virtual certainty.
ATM and OTM options are never exercised, since it is cheaper to buy or sell the stock in the open market than to exercise an option.
Option Premiums
The premium is the price paid or received for an option. Options are traded much like stocks, with bid and asked prices shown:
- Seller generally receives the bid price
- Buyer generally pays the asked price
- The market maker or specialist keeps the spread between the bid and asked prices.
Example: A stock is trading at $30, and the July 30 Call prices are quoted as follows:
Bid = 1.65 Asked = 1.70
This means the high bidder will pay $1.65, and the lowest price offered to buyers is $1.70. Note the 0.05 spread between the two prices.
Actually, the only time the seller can be assured of getting the bid price, or the buyer paying only the asked price, is to enter the trade order as a market order , in which case they get the market price at the time the order is executed.
Market makers have to execute a market order at market price, up to the number of contracts for which the bid or offer is good, but are not obligated to take limit orders. By using a limit order, the seller might get 1.70 or even 1.75 for writing the call. And the buyer can enter a limit order for less than 1.70 (ex: 1.65), in an attempt to buy the call more cheaply.
Historically, the premium referred to the total amount received for selling the contract, not to the option price. However, today the term “premium” simply means the option’s price on a per-share basis. That is, if the premium shown is bid at $0.80, that means $0.80 per share; you would expect to receive $80.00 ($0.80 x 100) for an entire option contract relating to 100 shares when using a market order. As we are about to see, premium is not just premium. The premium can be all intrinsic value, all time value, or contain both.
Option Premium: Intrinsic and Time Value
Intrinsic value is the portion of the premium that is in the money. Intrinsic increases dollar-for-dollar with the stock price as it moves. Only ITM calls have intrinsic value.
Intrinsic value = total premium – time value
Time Value is the portion of the premium that is not in the money. It is also known as “ extrinsic value ”. Time value is the amount upon which return is calculated in covered call writing. ATM and OTM premium is all time value. Time value = premium – intrinsic value.
Time value = total premium – intrinsic value
Calculating intrinsic and time value is simple. First, calculate the intrinsic value part of the premium. The remainder is time value. The entire premium of an ATM and OTM call will always be 100% time value. The following examples illustrate how to determine intrinsic and time value. In both examples assume the stock price is $20.
Example 1: ITM 17.50 Call – premium is $3.50:
Calculating Intrinsic Value | Calculating Time Value | |||
XYZ Stock price | 20.00 | Total premium | 3.50 | |
– Strike price | (17.50) | – Intrinsic value | ( 2.50) | |
Example 2: ATM 20 Call – premiums is $1.00:
Calculating Intrinsic Value | Calculating Time Value | |||
XYZ Stock price | 20.00 | Total premium | 1.00 | |
– Strike price | (20.00) | – Intrinsic value | ( 0) | |
Somehow, financial writers manage to make it sound as though the intrinsic value is the “real” or valuable part of the premium. Not so for the option seller!
The profit in covered call return calculations lies solely in the time value. Suppose for example that when the stock is $32.50 you were to write the 30 Call for a $3.00 premium, which seems fat.
But if assigned at the $30 strike price, you must sell the stock for $30. Thus your return will be the time value amount, which was only $0.50 (3.00 – 2.50 intrinsic value). Think of the intrinsic value as your money ; when selling the call, the intrinsic portion really is an advance payment of your money, since you could sell the stock and get the intrinsic amount immediately.
Note above in the intrinsic value definition that I said it increases dollar-for-dollar with the stock price. I am referring to the intrinsic value only. Suppose a stock is $30 and the current-month 30 Call can be sold for $1.25; obviously, the entire premium is time value since the call is not ITM.
If the stock moves up $1.00 to $31, the total premium may only increase $0.50 (to $1.75), not dollar-for-dollar with the stock. In this example, time value actually shrank from $1.25 to $0.75 with the stock’s rise. The 30 Call originally had $1.25 of time value, but the stock’s $1.00 price rise reduced the time value to $0.75 since the call is now $1.00 ITM.
Parity simply means that the option is trading precisely at intrinsic value and refers only to ITM options, since only they have intrinsic value. Options seldom trade more than a few pennies below parity (sub-parity). ITM options tend to trade at parity when:
- Expiration draws near and there is little time value left, or
- There is no expected volatility in the underlying stock.
Characteristics of the Three Call Strikes
ATM calls (at-the-money calls), which are all time value, offer the most time value premium and the largest returns. They also provide a reasonable degree of downside protection should the stock price drop. ATM options usually are the most heavily traded because they are worth more to the market. Why? The trader is not paying for intrinsic value.
OTM calls (out-of-the-money calls), which also are all time value, offer less time value premium than ATM calls and provide the least downside protection. OTM time value premium usually is higher than for ITM calls, at least in flat or rising markets.
ITM calls (in-the-money calls) usually offer the least time value premium, especially in a rising market, but the biggest downside protection. On a falling stock, though, their time value premium can be comparable to or better than for OTM calls.
Throughout these articles, we will be referring to options as ITM, ATM or OTM. The easiest way to keep them straight is to learn them for call options. Then remember that ITM and OTM are the opposite for put options.
Time decay means that the time value portion of the option premium will shrink as time runs out. The intrinsic value portion of ITM calls never shrinks due to passage of time.
Time decay accelerates in the last 30 days of an option’s life, and the most rapid time decay occurs in the last 10 days. Time decay is one of the two reasons for writing calls in the current expiration month. (The other is premium compression , which means that the more time you sell, the less premium you receive per month sold.)
Stock does not expire and thus its price is not affected by the passage of time. The fact that options expire by their own terms means that they lose value at a steady rate (until the last 30 days, at any rate) – the time decay. Effects of time decay:
- Time – time is on the side of the call writer, not the call buyer, because time locks in the call writer’s profit . That is, when the call expires worthless, the call writer keeps all net premium received. On the other hand, time eventually destroys the option and thus the call buyer’s entire investment .
- The Ex-Monday Drop – time decay also explains why the premium for an option drops on the Monday following expiration, when the near-month option becomes the front month.
The following graph illustrates how an option loses value (decays) with the passage of time. Note the acceleration of time decay in the last 30 days and the very rapid acceleration in the last 10 days. Of course, it is the time value portion of option premium that decays; intrinsic value never decays.
Figure 2.6
The time remaining in days to expiration is an important time factor. In legal terminology, an option is a wasting asset (it expires naturally with time), and as the option’s expiration date gets closer, the value of the option decreases.
The more time remaining until expiration, generally the more time value the option contract has. If the underlying asset price falls far below or far above the strike price of the option, the price of underlying asset in relation to the strike price becomes more significant in determining the option’s price.
On the day the option expires, the only value the option contract has is its intrinsic value, if any (ITM options).
Theta is the expected change in an option premium for a single day’s passage of time. That is, if all other factors are not changed, then option premium should be lower the next trading day by the theta value. Theta, then, expresses time decay of an option’s time value.
>> More: Introduction To Options
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What are option exercise and assignment?
Exercise and assignment—an example, exercising your options—american vs. european, cash settlement vs. physical delivery, the bottom line.
Option specs: American vs. European exercise; physical vs. cash settlement
Before you trade a single option contract —either as a buyer or seller—there are several key terms and specifications you need to know.
You don’t want to be the person who gets to the last day of an option’s life and doesn’t know whether your option will convert to a stock or futures position due to an exercise or assignment, or if you’ll be required to fork over money to square up a cash-settled position. And with some contracts, your exercise/assignment decision might come before that final day.
No idea what these terms mean? Don’t make that first trade until you know how these contract terms and logistics work.
- American-style options can be exercised anytime before expiration, whereas European options are exercised only at expiration.
- Some options are settled via cash, while others (including options on stocks and ETFs) involve the actual transfer of the security.
- Most contracts are closed out before expiration, but it’s still important to understand the mechanics.
Exercise. As the holder of a long option contract, you have the right but not the obligation to buy (in the case of a call option) or sell (in the case of a put option) the underlying instrument (stock, index, ETF, or other asset) at the strike price purchased. Converting your option contract into the underlying means you are “ exercising ” your right to be long or short the underlying instrument at your strike price.
Each standard equity (“stock”) and ETF option contract is deliverable into 100 shares. So if you exercise a call, you’ll acquire 100 shares; if you exercise a put, you’ll get a short position. If you happen to hold the opposite position in your account, your exercise will be matched against it. For example, if you own 100 shares of XYZ, and you exercise one XYZ put option contract, you’ll deliver the 100 shares you own.
But note: If you plan to take on a new long or short position with an exercise or assignment, make sure you’re able to do so. For example, if you exercise a 50-strike call option in XYZ, you need to have $5,000 in your account in order to buy the shares. On the flip side, some accounts aren’t permissioned for short selling of stocks and ETFs ( short selling is risky and complicated ), so if you plan to exercise a put, make sure you can.
Assignment. Once the owner of an option contacts their broker to exercise it, an option seller (or “writer”) with an open short position—perhaps you, if you hold a short position—in the same contract will be assigned (through a sort of lottery system) to deliver the underlying shares. Option sellers take on the obligation to potentially deliver the long or short position to the option buyer when a position is opened and a premium changes hands.
Suppose it’s 4:01 p.m. ET on the third Friday of the month (which is expiration day for standard monthly equity and ETF options). Two months earlier, you bought a call option on XYZ stock at a $50 strike price that expires today. The contract gives you the right, but not the obligation, to purchase 100 shares of the underlying for $50 a share until the expiration date.
As it turns out, the last trade of the day settled at $50.02 and you didn’t close the contract. What happens now? You’ll receive a notice from your broker stating that your option contract was automatically exercised into 100 shares of XYZ at $50 per share. Your account will be debited $5,000 and you’ll be the proud owner of 100 shares. Alternatively, if you have a margin account that’s set up to purchase shares on margin in lieu of cash, your account might reflect a change in margin borrowed.
On the other side of this transaction, an option writer on the same contract will receive an assignment notice , instructing them to deliver 100 shares of the underlying to you, the buyer.
At first blush, you may think American versus European exercise is a geographical thing. Nope. It is simply the handle given to two different expiration protocols.
American-style exercise. This style gives you the right to exercise your option contract into the underlying shares anytime before expiration. Why would you want to do this? Two top reasons:
- To capture a dividend. Dividends on stocks (including stocks within an ETF) are issued to the owner of record as of the so-called “ex-dividend date.” So if you hold a call option, and there’s a dividend to be issued between now and the option’s expiration, pay attention; you might be better off exercising the option early.
- You’re ready to move on. Suppose you have a hedged option position—a long put option against a long stock position, for example. Maybe the stock has fallen way below the strike price, and you plan to exercise it, thereby delivering the stock and thus your stock position. If it’s a virtual certainty that the option will finish in the money, why wait? You have money tied up in premium, and those dollars could be better deployed elsewhere—even in an interest-bearing account.
The exercise decision is based on math and probabilities. When you exercise an option, you’re essentially giving up the choice. So you need to make sure there’s no inherent value left in that choice (what option traders call extrinsic value). Even when you’re looking to capture a dividend, if there’s extrinsic value left in the option, you might be better off selling the option (capturing the remaining extrinsic value) and buying the stock. Again, follow the math.
Examples of American-style expiration include equity and ETF options, as well as some options on futures contracts.
European-style exercise. European-style options can be exercised only on their expiration date—not before. That makes it easy, for the most part, particularly if the settlement price is set concurrently with the option expiration time.
But beware: Some European cash-settled options, including monthly and quarterly options on broad-based indexes such as the S&P 500 (SPX), expire on a Thursday afternoon but the settlement price is based on where the index opens the following morning (Friday).
This can leave an option holder subject to so-called “overnight risk” if the option contracts still have considerable value.
Cash settlement. European options are often—but not always—settled in cash. Here’s how it works:
- Options with intrinsic value (i.e., in the money) are exercised. Out-of-the-money options expire worthless.
- If you own an option that’s exercised, you’ll receive a cash payment of the intrinsic value (the difference between the strike price and the settlement price of the underlying index or other security) times the contract’s multiplier.
The multiplier on SPX options is $100. If you held a 3900 SPX call and, at expiration, the SPX settled at 3940, you’d receive a cash payment of (3940 – 3900) x $100 = $4,000. If you were short the 3900 call, your account would be charged (“debited”) $4,000.
If you held a 3950 call, it would expire worthless, so you’d receive no cash.
If you held a 4000 put option, you’d receive a cash payment of (4000 – 3940) x $100 = $6,000.
Physical delivery. Options on stocks and ETFs, as well as some futures contracts , are settled by exchanging the actual securities or physical product. In the case of equity and ETF options, each contract is deliverable into 100 shares of the underlying.
- Exercising a long call or being assigned on a short put will result in a long position of 100 shares.
- Exercising a long put or being assigned on a short call will result in a short position of 100 shares. But remember: Your account must have the appropriate account permissions (and sufficient funds) in place before expiration.
If you exercise a physically settled futures option, you’ll take a position in a futures contract. For example, if you exercise a Dec 2023 WTI Crude Oil (CLZ3) call option, you’ll be long one contract for December 2023 delivery of 1,000 barrels of crude oil. If you’re interested in the ins and outs of futures contract specs, here’s an overview .
Remember: Unlike cash settlement, physical settlement will result in a position change in your account. Unless and until you offset or liquidate that position, after expiration, you’re subject to the ups and downs of the market.
Options on stocks, ETFs, indexes, and futures allow you to speculate, hedge, or otherwise customize your risk and reward . But before you begin, it’s imperative that you understand all the contract specifications. And unless you’re absolutely, positively certain that you’ll liquidate your option positions before expiration, you need to know all the facets and mechanics of option exercise and assignment, including American versus European exercise and cash versus physical settlement.
The last thing you want is to receive an unexpected notice from your broker indicating that you’re now the proud owner of a position you didn’t want.
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Should an Investor Hold or Exercise an Option?
Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).
Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.
When is it time to exercise an option contract? That's a question that investors sometimes struggle with because it's not always clear if it's the optimal time to call (buy) the shares or put (sell) the stock when holding a long call option or a long put option.
There are a number of factors to consider when making the decision, including how much time value is remaining in the option, whether the contract is due to expire soon, and whether you really want to buy or sell the underlying shares .
Right to Exercise Options
When newcomers enter the options universe for the first time, they usually start by learning the various types of contracts and strategies. For example, a call option is a contract that grants its owner the right, but not the obligation, to buy 100 shares of the underlying stock by paying the strike price per share, up to the expiration date.
Conversely, a put option represents the right to sell the underlying shares.
Key Takeaways
- Knowing the optimal time to exercise an option contract depends on a number of factors, including how much time is left until expiration and if the investor really wants to buy or sell the underlying shares.
- In most cases, options can be closed (rather than exercised) through offsetting transactions prior to expiration.
- It doesn't make a lot of sense to exercise options that have time value because that time value will be lost in the process.
- Holding the stock rather than the option can increase risks and margin levels in the brokerage account.
The important thing to understand is that the option owner has the right to exercise . If you own an option, you are not obligated to exercise; it's your choice. As it turns out, there are good reasons not to exercise your rights as an option owner. Instead, closing the option (selling it through an offsetting transaction) is often the best choice for an option owner who no longer wants to hold the position.
Obligations to Options
While the holder of a long option contract has rights, the seller or writer has obligations. Remember, there are always two sides to an options contract: the buyer and the seller. The obligation of a call seller is to deliver 100 shares at the strike price . The obligation of a put seller is to purchase 100 shares at the strike price.
When the seller of an option receives notice regarding exercise, they have been assigned on the contract. At that point, the option writer must honor the contract if called upon to fulfill the conditions. Once the assignment notice is delivered, it is too late to close the position, and they are required to fulfill the terms of the contract.
The exercise and assignment process is automated and the seller, who is selected at random from the available pool of investors holding the short options positions, is informed when the transaction takes place. Thus, stock disappears from the account of the call seller and is replaced with the proper amount of cash; or stock appears in the account of the put seller, and the cash to buy those shares is removed.
Four Reasons Not to Exercise an Option
Let's consider an example of a call option on XYZ Corporation with a strike price of 90, an expiration in October, and the stock trading for $99 per share. One call represents the right to buy 100 shares for $90 each, and the contract is currently trading for $9.50 per contract ($950 for one contract because the multiplier for stock options is 100).
- XYZ is currently trading at $99.00.
- You own one XYZ Oct 90 call option.
- Each call option gives the right to buy 100 shares at the strike price.
- The XYZ Oct 90 call option is priced at $9.50.
- October expiration is in two weeks.
1. Time Value
A number of factors determine the value of an option, including the time left until expiration and the relationship of the strike price to the share price. If, for example, one contract expires in two weeks and another contract, on the same stock and same strike price, expires in six months, the option with six months of life remaining will be worth more than the one with only two weeks. It has greater time value remaining.
If a stock is trading for $99 and the Oct 90 call trades $9.50, as in the example, the contract is $9 in the money , which means that shares can be called for $90 and sold at $99, to make a $9 profit per share. The option has $9 of intrinsic value and has an additional 50 cents of time value if it is trading for $9.50. A contract that is out-of-the-money (say an Oct 100 call), consists only of time value.
It rarely makes sense to exercise an option that has time value remaining because that time value is lost. For example, it would be better to sell the Oct 90 call at $9.50 rather than exercise the contract (call the stock for $90 and then sell it at $99). The profit from selling 100 shares for a profit of $9 per share is $900 if the option is exercised, while selling a call at $9.50 equals $950 in options premium . In other words, the investor is leaving $50 on the table by exercising the option rather than selling it.
Furthermore, it rarely makes sense to exercise an out-of-the-money contract. For example, if the investor is long the Oct 100 call and the stock is $99, there is no reason to exercise the Oct 100 call and buy shares for $100 when the market price is $99.
2. Increased Risks
When you own the call option, the most you can lose is the value of the option or $950 on the XYZ Oct 90 call. If the stock rallies , you still own the right to pay $90 per share, and the call will increase in value. It is not necessary to own the shares to profit from a price increase, and you lose nothing by continuing to hold the call option. If you decide you want to own the shares (instead of the call option) and exercise, you effectively sell your option at zero and buy the stock at $90 per share.
Let's assume one week has passed and the company makes an unexpected announcement. The market does not like the news and the stock sinks to $83. That's unfortunate. If you own the call option, it has lost a lot, maybe almost worthless, and your account might drop by $950. However, if you exercised the option and owned stock prior to the fall, your account value has decreased by $1,600, or the difference between $9,900 and $8,300. This is less than ideal because you lost an additional $650.
3. Transaction Costs
When you sell an option, you typically pay a commission . When you exercise an option, you usually pay a fee to exercise and a second commission to buy or sell the shares.. This combination is likely to cost more than simply selling the option, and there is no need to give the broker more money when you gain nothing from the transaction. (However, the costs will vary, and some brokers now offer commission-free trading—so it pays to do the math based on your broker's fee structure).
4. Higher Margin Exposure
When you convert a call option into stock by exercising, you now own the shares. You must use cash that will no longer be earning interest to fund the transaction, or borrow cash from your broker and pay interest on the margin loan . In both cases, you are losing money with no offsetting gain. Instead, just hold or sell the option and avoid additional expenses.
Options are subject to automatic exercise at expiration, which means that any contract that is in the money at expiration will be exercised, per rules of the Options Clearing Corporation.
Two Exceptions
Occasionally a stock pays a big dividend and exercising a call option to capture the dividend may be worthwhile. Or, if you own an option that is deep in the money , you may not be able to sell it at fair value . If bids are too low, however, it may be preferable to exercise the option to buy or sell the stock. Do the math.
The Bottom Line
There are solid reasons for not exercising an option before and into the expiration date . In fact, unless you want to own a position in the underlying stock, it is often wrong to exercise an option rather than selling it. If the contract is in the money heading into the expiration and you do not want it exercised, then be sure to close it through an offsetting sale or the contract will be automatically exercised per the rules of the Options Clearing Corporation.
Options Clearing Corporation. " OCC By-Laws: General Rights and Obligations of Holders and Writers ," Page 72-73.
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Options Allocation of Exercise Assignment Notices
FINRA Rule 2360(b)(23)(C) requires member firms conducting transactions in exchange-listed options to establish fixed procedures for allocating options exercise assignment notices to short options positions in their customer accounts. Firms may elect to allocate exercise assignment notices on: (1) a “first in-first out” basis (FIFO); (2) a random selection basis; or (3) another equally random selection basis determined by the firm. However, firms must receive prior FINRA approval for the method selected. Any changes to a firm’s allocation method must be reported to and approved by FINRA.
As detailed in Regulatory Notice 11-35 , firms initiating an options business, changing their clearing firm, or changing their allocation method, must submit the form to [email protected] for approval. Also in Regulatory Notice 11-35, FINRA clarified its designated procedures for firms employing a random method of allocating options exercise assignment notices. Firms using the random method must ensure that they follow these updated procedures or seek approval from FINRA for an alternative allocation method.
Firms must inform customers in writing of the method used to allocate options exercise assignment notices, including explanations of how the system operates and the consequences of that system. Firms also must preserve sufficient work papers and other documentary materials relating to the allocation of options exercise assignment notices to establish the manner in which allocation of the exercise assignment notices is in fact being accomplished.
Firms that receive specific requests on behalf of a group of accounts under common ownership for an exception from their approved method of allocating options exercise notices to permit reallocation of exercise assignment notices for such accounts, must submit those reallocation instructions to [email protected] for approval as part of their overall allocation method. This exception can only be applied after the firm’s approved method has completed and has no impact on the number of contracts allocated to other accounts. A firm must detail (i) its original methodology for the accounts in question, (ii) the new methodology proposed for those accounts and reason for the change, and (iii) the customer and specific accounts affected by the requested change in methodology. If the information provided is acceptable, FINRA will issue an approval letter with respect to the reallocation method requested for specified accounts.
For questions regarding the allocation form, or the allocation process, please contact:
- Max Tourtelot (212) 457-5366
- James Turnbull (212) 457-5367
- FINRA Rules 2360. Options
- Regulatory Notice 11-35 FINRA Modifies the Process for Firms to Designate Their Allocation Methodology for Options Exercise Assignment Notices 07/29/2011
IMAGES
VIDEO
COMMENTS
Managing an options trade is quite different from that of a stock trade. Here are 4 things you should know to decide whether you exercise, roll, assign, or let your options contract simply expire.
Learn how to navigate options exercise, assignment, and expiration, plus explore the mechanics of options expiration before your first options trade.
In this guide, you'll learn about exercise and assignment, which explain an option's conversion to shares of stock.
Understand the process of exercise and assignment in when buying and selling options contracts. Learn more.
Just because you can, does it mean you should exercise your options? Find out how options traders navigate the world of exercise and assignment.
An option assignment represents the seller's obligation to fulfill the terms of the contract by either selling or buying the underlying security at the exercise price. This obligation is triggered when the buyer of an option contract exercises their right to buy or sell the underlying security. To ensure fairness in the distribution of American ...
y, selecting strike, and a up with session three here, first talking about exercise and assignment, what need to know and how commentary about the possibility of early exercise and assignment, where oes that occur, and then also monitoring your trades. I'm going to pi about what you can do give different stock price movements and what type of
A concise, illustrated tutorial on the mechanics of the trading, exercise and assignment of options.
Before entering an options trade, traders should consider the possibility of early assignment. Learn more about assignment and how to help reduce the risks associated with it.
Option assignment is when the option buyer exercises the option and the seller is required to fulfill the obligation of the option contract's terms.
Assignment. The holder of an American-style option contract can exercise the option at any time before expiration. Therefore, an option writer may be assigned an exercise notice on a short option position at any time before expiration. If an option writer is short an option that expires in-the-money, they should expect assignment on that ...
Exercise means to put into effect the right specified in a contract. In options trading, the option holder has the right, but not the obligation, to buy or sell the underlying instrument at a ...
Exercise & Assignement - A Guide Exercise & Assignment: There are many questions asked over and over with exercise and assignment being among the most common and repetitive. I was asked to put together a guide that can hopefully be used to answer many of these so here it is!
Early options exercise strategy for calls and puts. Multi-leg call and put options are more likely to be exercised before the expiration date.
When an investor decides to exercise an option, they are buying or selling stocks specified in the options contract. Learn how exercising an option can be advantageous to an investor and when it does not make sense.
Learn what options assignment is and how it works. How are options exercised and what does it mean to "write an option"?
Option Expiration, Exercise, Assignment, and the Potential Risks Option Expiration: Expiration Day typically occurs Friday, or Thursday if that is the last trading day of the week. However, certain securities may also have Monday, Wednesday, or Quarterly expiration days.
Exercise and Assignment The exercise process begins with an investor who is holding a long option position and has decided to exercise their right to either purchase (call) or sell (put) the undelying security. In some instances, the process occurs automatically. In others, the investor must notify their brokerage firm. Regardless of the method, the brokerage firm then submits exercise ...
Learn about options exercise and options assignment before taking a position, not afterward. This guide can help you navigate the dynamics of options expiration.
Exercise and Assignment. When a stock option is exercised, the call holder buys the stock, and the put holder sells stock. When options are exercised, the OCC decides to which brokerage firm, such as TastyWorks, the exercise will be assigned, and the brokerage in turn decides which customer will get the assignment.
Learn about option contract terms. American-style options can be exercised anytime before expiration, whereas European options are exercised only at expiration. Some options are settled via cash, while others (such as options on stocks and ETFs) involve the actual transfer of securities. Most contracts are closed out before expiration, but it's still important to understand the mechanics.
There are times when a trader or investor shouldn't exercise an option. Find out when to hold and why you shouldn't exercise an option.
Firms must inform customers in writing of the method used to allocate options exercise assignment notices, including explanations of how the system operates and the consequences of that system. Firms also must preserve sufficient work papers and other documentary materials relating to the allocation of options exercise assignment notices to establish the manner in which allocation of the ...
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