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Option Exercise & Assignment
To exercise an option is to execute the right of the holder of an option to buy (for call options) or sell (for put options) the underlying security at the striking price.
American Style vs European Style
American style options can be exercised anytime before the expiration date. European style options on the other hand can only be exercised on the expiration date itself. Currently, all of the stock options traded in the marketplaces are American-Style options.
When an option is exercised by the option holder, the option writer will be assigned the obligation to deliver the terms of the options contract.
Assignment takes place when the written option is exercised by the options holder. The options writer is said to be assigned the obligation to deliver the terms of the options contract.
If a call option is assigned, the options writer will have to sell the obligated quantity of the underlying security at the strike price.
If a put option is assigned, the options writer will have to buy the obligated quantity of the underlying securty at the strike price.
Once an option is sold, there exist a possibility for the option writer to be assigned to fulfil his or her obligation to buy or sell shares of the underlying stock on any business day. One can never tell when an assignment will take place. To ensure a fair distribution of assignments, the Options Clearing Corporation uses a random procedure to assign exercise notices to the accounts maintained with OCC by each Clearing Member. In turn, the assigned firm must use an exchange approved way to allocate those notices to individual accounts which have the short positions on those options.
Options are usually exercised when they get closer to expiration. The reason is that it does not make much sense to exercise an option when there is still time value left. Its more profitable to sell the option instead.
Over the years, only about 17% of options have been exercised. However, it does not mean that only 17% of your short options will be exercised. Many of those options that were not exercised were probably out-of-the-money to begin with and had expired worthless. In any case, at any point in time, the deeper into-the-money the short options, the more likely they will be exercised.
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When we talk to our customers, one of their biggest fears when learning how to trade options is getting assigned stock (because remember, when you buy/sell an option, you control 100 shares of that option’s stock). Well, I’m hoping to help you put that anxiety to rest with this post.
Assignment of stock when trading options is just like being given a pop quiz in school - it’s generally unexpected, and usually not a good feeling!
Some people like to be assigned stock as a part of their strategy (i.e. one of the follow traders, Woody, likes to sell puts at a strike price that he is comfortable being assigned stock at, and will always take the assignment when his options are expiring in the money), but this post is more focused on those who do not want to be assigned stock.
The 3 most common questions we get asked related to trading options and being assigned stock are:
- What situations would cause me to get assigned stock?
- What can I do to prevent being assigned stock?
- And…If I am assigned, what should I do?
WHEN WILL I GET ASSIGNED?
Let's tackle the first question that asks...when you invest in options, what scenario would cause you to be assigned shares of stock?
The most common way you will be assigned stock is if you short (sell) an option that expires in the money.
Assignment Risk: Buying An Option
When you buy an option (a call or a put), you cannot be assigned stock unless you choose to exercise your option. Plain and simple, the purchaser of an option contract will always have the choice to exercise the option, but not the obligation to do so.
Let’s say you bought an Apple (ticker symbol AAPL) option a few weeks ago that is set to expire today and the option is in the money (there is never risk of assignment if the option is not in the money), you may do one of two things:
- you can let the option expire in the money and collect the profit, or...
- you can exercise the option and collect 100 shares of the stock
Easy enough to understand, right?
Let’s now break that down even further, by looking at buying calls and buying puts separately to reinforce your understanding.
Assignment When Buying A Naked Call
Remember that if you buy a call, that gives you the right to buy 100 shares of stock at an agreed upon strike price. Let's take a look at an example scenario of getting assigned on a naked call.
As the call buyer, you have the choice whether or not you want to exercise the option. If you exercise your right to purchase shares of the stock (100 shares for each option contract), the seller of the call (let's call him Mike) will automatically have 100 shares called away from his account.