Option Assignment and Exercise

It’s not sexy, but option assignment and exercising is something you need to know before trading options.

One of the first things to keep in mind about call and put transactions is that two parties are involved in both of them. They are the party that is writing the contract, or selling the option. The other party is the one that is buying it.

The term exercise is used when the owner of a call or put “exercises” his or her right to buy or sell the stock. As noted above, they buy it if it the option is a call and they sell it if it is a put. The term assignment is used when someone has a short position in a call or put and is called upon to fulfill their obligation by someone who is exercising their rights. Unlike exercising the option, assignment means they must sell if it is a call and they must buy it if it is a put.

Enter the OCC

In the case of assignments, you would receive an assignment notice when your short options are assigned. The Options Clearing Corporation (OCC) acts as the middle man between buyers and sellers of options and is responsible for  the assignment process. It sends assignment notices to its members (i.e. brokers), which use “an exchange approved method (usually a random process or the “first-in, first-out” method) to allocate those notices to accounts which are short the options.”

An interesting tidbit about the OCC relates to its provisions for the automatic exercise of certain in-the-money options at expiration. According to the Chicago Board Options Exchange (CBOE), a procedure referred to as “exercise by exception” allows the OCC to automatically exercise any expiring equity call or put in a customer account that is $0.01 or more in-the-money. It can do the same for an index option that is $.01 or more in-the-money. However, a specific brokerage firm’s threshold for such automatic exercise may or may not be the same as OCC’s, notes the CBOE.

American and European Options Now that you’ve gotten the gist of what exercise and assignment mean, let’s look at the two different styles of options – European and American.

Contrary to their names, these styles do not refer to countries, continents or what exchanges they are traded on. These styles instead are used to determine how an option’s contract can be exercised or assigned.

With American-style options, the contract can be exercised at any time before the expiration date. However, with European-style options, the contract can only be exercised on the expiration date. Another key difference between American-style options and European-style options deals with the last day they can be traded. American-style index option contracts can be traded up until expiration on Friday. If that day is a holiday when the markets are closed, the last day would be the previous day.

European-style index option contracts can be traded up until the business day before the day the settlement value is calculated. The last trading day is generally a Thursday, and the day the settlement value is calculated is Friday unless that day is a holiday.

Keep this in mind, too. Equity calls and puts traded in the U.S. are typically American style. However, index options traded in the U.S. tend to be European style. Keep in mind that “either style of option can still be bought or sold to close your position in the marketplace at any point during the contract’s lifetime.”

Why Would You Choose European-style Options Given you are taking one heck of a risk in trading options in the first place, you may ask why in the world would you choose the European style since it means you won’t be able to exercise the contract before the expiration date.

For one thing, they tend to be cheaper than American-style options. That’s due to the chance that a stock’s price will go up before the expiration date. If this happens, holders of American-style call options (remember you buy calls if you think the price will go up) can take advantage on the higher value that comes from the stock’s price moving up.

Exercising Calls Early Many options market players will tell you to avoid exercising your option contracts early. The reason is due to the likelihood that any option premium you could gain as the expiration date nears could be lost.

Still, there are times when exercising the option early is worth it. Let’s take a scenario in which you have a call option that is deep in-the-money before the underlying stock goes ex-dividend. By exercising the option early, you could capture that dividend, which could considerably make up for the loss of option premium caused by the early exercise.

Also noteworthy is what usually happens to a stock’s price after it goes ex-dividend. It falls. What does this do? It causes the value of the call to fall. So, there would hardly ever be a reason to exercise a call early if the underlying stock doesn’t pay a dividend.

Exercising Puts Early Exercising American style puts before expiration directly relates to being able to collect any interest your investment has gained from shorting the underlying stock. In this scenario, you may do yourself justice in exercising the contract early if the put is in-the-money after the ex-dividend date because this would likely cause the stock’s price to rise. (recall that exercising calls is best when done before the underlying stock goes ex-dividend).

According to CBOE, most professional traders will exercise deep in-the-money puts that have little or no time premium remaining. For more information on exercise and assignment, Thinkorswim has some good information as does the CBOE.

Getting Assigned On A Multi-Leg Strategy I have to be honest, this is a real pain in the ass when this happens. If you have a butterfly spread for example, and the short options get assigned it can be a tricky situation. My advice in this situation is to close the remaining legs and get what you can out of the trade. The better advice is to try and avoid this situation in the first place. If you have a trade with short options that are in-the-money or at-the-money you should check when the dividend is due and get out of the trade beforehand. Also, the close you get to expiry, the more likely you are to be assigned due to the lack of time premium.

Who’s Keeping Track of All of This? A body called the Options Clearing Corporation is charged with clearing put and call transactions. Due to its charge, it falls under the jurisdiction of the SEC. It touts providing central counterparty (CCP) clearing and settlement services to 17 exchanges and trading platforms, including for options.

Conclusion Options trading can be challenging at the best of times without having to deal with your short options being assigned.

Hopefully now you have a good understanding of what is involved and how to handle it.

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  1. Gavin
    13 hours ago

    This is an email I received from a reader on this very topic. Thought it was worth sharing:

    Thanks for the post, Gavin! This just happened to me last week with a 4-contract 196/198 SPY Call spread that was in the money. Last Thursday, the day before expiry, the 196 short leg got exercised, leaving -$80,000 in my account. I immediately exercised the 198 longs, but had to swallow an additional $375 dividend pay on top of the loss of the spread. Ouch!! (you might want to mention that in your blog…). I thought my risk was limited to $800 minus the $300 credit. This almost doubled my loss!!

    Your post is helpful in explaining this. Wish I knew this before last week, but alas… it’s an expensive lesson that I will not forget!

    Dick

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