Breaking Down Options Assignment

What happens when a buyer decides to exercise that option

Managing Editor
Mar 9, 2018 at 1:27 PM
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    Last week we talked about how and when to exercise options, and to explore the category further, this week we are looking at the flip side of the coin -- options assignment. There are two sides to an options trade: the buyer and the seller. It's important to remember that only buyers can exercise an option. When an option is exercised by the buyer, the seller of that option is required to act -- or is assigned.

    Who Can Be Assigned and When is Assignment Risk Highest?

    For put sellers, getting assigned means they're required to buy the underlying shares at the strike price. Call sellers, on the other hand, are required to sell the underlying shares at the strike price if assigned. 

    With that said, something important to remember is that most options are not exercised at all -- they will either expire worthless or are closed before expiration. However, while an option can be exercised at any point within its lifetime, the risk of assignment goes up as it moves deeper into the money and approaches expiration.

    If an option is in the money at expiration, even by a penny, it will be automatically exercised. To avoid assignment, however, sellers should buy to close the option before expiration.

    Strategies That Carry Assignment Risk

    Selling to open a call or put carries assignment risk. For instance, say you sell to open an XYZ 100-strike call, and XYZ moves to $105 before expiration. The call buyer decides to exercise the in-the-money option, and because you've been assigned, you're forced to sell 100 shares of XYZ at $100 apiece -- a discount to what you'd get on the Street.

    If you already owned XYZ shares, your sold call was "covered" -- and the option may have been sold to immediately generate a premium payment on a stock not living up to your short-term expectations. Still, don't use covered calls to generate income on a stock unless you're comfortable selling your shares at the strike price in the event of assignment.

    If unaccompanied by previously owned shares or a bought call at a higher strike (as in a short call spread), your short call was also known as a "naked call." That's because you're completely un-hedged, and therefore vulnerable to potentially steeper losses.

    Why Sell Options?

    Typically, the goal of writing, or selling an option is for it to expire worthless, or out of the money. Therefore, if you sell to open an XYZ 100-strike put, and XYZ is trading at $101 on expiration day, the option will expire worthless and you can keep the total credit you received for the put at initiation. From the other side of things, if you sell to open an XYZ 100-strike call, and XYZ is trading at $99 on expiration day, the option will expire worthless and you can retain the total credit.

    Meanwhile, some traders will sell puts at strike prices that align with what they view as attractive entry prices on the underlying, because they can then buy into the stock on a dip, while simultaneously getting paid via the put-sell credit. In this case, they're hoping to be assigned, but the "worst case scenario" is that they don't get assigned and can keep the initial premium as profit on the trade.

     

     

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