Options Basics: How the Option Assignment Process Works

Breaking down how options assignment works for options traders

Jul 23, 2021 at 12:46 PM
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    There is a lot of technical jargon that is specific to the options market. For a beginner who is aiming to learn how to trade options, understanding these technical terms is crucial to optimizing trading results. One phrase that is a critical part of this options trading language is “assignment.” Simply defined, the assignment of an option refers to the fulfillment of the options contract by the seller. An option holder has the right to buy or sell the underlying equity at the given strike price. Once the holder decides to exercise the option, the option is said to be “assigned.” If a trader sells options, he must be aware of the assignment process and the risks it entails. We recommend subscribing to one of Schaeffer's options trading newsletters to gain the ultimate insights into the language of the options market while making money, too.

    What Does it Mean to Write an Option?

    When an options seller writes an options contract, this is known as a “sell to open” trade, as he is essentially opening a new position. As the trader is selling the option to open this position, he is technically said to be “short” that underlying stock. The seller accepts a responsibility to sell or buy the underlying security in lieu of a premium received from the buyer. As a general rule, an option holder can exercise his rights any time before the contract expires. In order to learn to trade options, it is necessary to grasp this structure of corresponding rights and duties. It's important to also note that most options are exercised when they are nearing expiry because, after that, the options contract is worthless.

    How Does the Option Assignment Process Work?

    The assignment process is done at random by the Options Clearing Corporation (OCC). A trader will become more acquainted with the operations of the OCC as he or she learns to trade options. When a buyer exercises his option, the OCC will randomly connect them with a brokerage that is short on options of that equity. Due to the lottery-like nature of the process, it is almost impossible to predict when an investor’s option may be assigned.

    2 Categories of Options to Understand

    As a brief summary, let’s go over the two basic categories of options. These categories and their respective merits become apparent as one learns to trade options. In a call option, the option holder possesses the right to buy the security before the contract expires. In this scenario, the seller’s obligation is to sell the option upon assignment.

    The inverse of this is the put option. In this category, the holder has the right to sell to the security at the contract price. The consequence of this is that upon assignment, the seller must purchase the security at the strike price. If an investor does not own the stock, he must first buy it. After this, he must deliver it to the holder.

    Initially, a seller has an edge in the options trading process. He starts with a net benefit as a premium is paid to him by the buyer without him giving any monetary return immediately. If an option is never exercised, the seller actually retains the premium if the contract expires.

    However, the issues arise as the contract nears its expiry, as the chances of assignment increase exponentially. The problem for investors when called to assign are three-fold: 1) they have no control over when the option is exercised, 2) they must fulfill their end of the bargain irrespective of whether this could lead to a loss or a low gain, and 3) even if the underlying stock is not trading, in a call option the deliver the stock to the buyer.

    Can an Options Seller Predict When an Option Will Be Exercised?

    It would be misleading if we were say there is some magic formula that we could use to predict when an option will be exercised. Traders will understand how frequent assignment occurs once they more completely learn to trade options. However, a general statistic is that approximately 7% of options are actually ever exercised. Even though, technically, an option can be assigned any time while the contract remains open, option holders usually exercise their option near its expiration date. This is because traders usually wait to find the ideal time and observe trading prices. As you learn to trade options, you will realize that very few buyers ever exercise options ahead of expiration.

    When is Options Assignment Less Likely?

    Even though we cannot accurately predict when an option will be exercised, there are certain indicators traders can use. These indicators are easier to see when you learn to trade options and observe market trends.

    An assignment is less probable when an option is out-of-the-money. An option is out-of-the-money when the security is trading at a higher value in the market as compared to the strike price. It is rarely recommended to sell an option that is out-of-the-money. This is because if the strike price is lower than the market value, the option holder will make a loss on the contract. If the strike price is $30, and the market value is $20 and the holder exercises the call option, they will end up taking a loss since they are buying it at a higher price. As investors learn to trade options, they can better predict the time of assignment with greater accuracy.

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