Being Assigned an Exercise Notice: No Big Deal

Surfing online forums, I frequently encounter questions from option sellers who are extremely concerned about being assigned an exercise notice on an option they sold.  Usually these questions come from newcomers to the options world.

When an option owner exercises his/her rights and elects to buy (by exercising a call option) or sell (by exercising a put option) stock at the strike price, someone (randomly chosen) who currently holds a short position in that option is assigned an exercise notice and must honor the conditions of the option contract.

Receiving an exercise notice should not be a problem, unless one of two different conditions obtains.

  • You are underfunded and being forced to buy or sell stock, as the result of an assignment, results in a margin call.
  • You are trading OEX options.  These options are cash-settled and American style, and being assigned on these presents so much potential risk that I recommend not trading OEX options.

When assigned an exercise notice on a call option, you simply sell 100 shares of stock (or an ETF – exchange traded fund).  Your upside risk is unchanged.  Your downside risk has improved. Why? If the stock eventually falls below the strike price at which you were assigned, you earn extra profits.

Example:  You have some spread position in which you are short one XZZ Nov 60 call.  Two weeks prior to expiration, XZZ is trading near $75 per share, the call is trading near $15, and someone (makes a mistake) and exercises the call and you are assigned.  You are no longer short the call.  Instead, you must [CORRECTION] SELL 100 shares at the strike price.

You have lost nothing.  You repurchase the call at zero (gaining $1,500 compared with the value of this option yesterday) and sell stock at $60 (losing the same $1,500 compared with yesterday's closing stock price). 

But look what happens if the stock issues bad news prior to expiration.  If the stock falls to $52, the call is worthless and you would have gained the original premium.  Instead, you buy back the stock by paying $52 – not only collecting that option premium, but also earning an additional $800 profit – that you could not have earned if you were still short the call.  In other words, it's as if you repurchased the call option and collected an $800 bonus for buying it.

Consider the unfortunate option exerciser.  Had he/she not exercised, he/she would have lost $1,500 (from the day of the exercise).  Instead, he/she lost $2,300 when the stock moved from 75 to 52.

Being assigned early is nothing to fear.

148

10 Responses to Being Assigned an Exercise Notice: No Big Deal

  1. anonymous 10/27/2008 at 9:56 AM #

    Another situation which has become more common in these volatile markets – if you sold calls naked and you get assigned, your broker may not be able to locate shares to short, and you may find yourself taken out of your position.

  2. Mark 10/27/2008 at 10:32 AM #

    True. Although there have not been that many instances of stocks rising so rapidly – at least recently, you raise a good point. Selling call options in stocks that are difficult to borrow has it’s own special risk.
    Mark

  3. JB 10/27/2008 at 11:02 PM #

    Hi Mark,
    Would speak more about the risks of being assigned on the cash-settled, American style, OEX options. The bid-ask spreads look lower and, at least for SPY, there are many more strike prices to choose from allowing more flexibility in setting the spread between the short and long strikes.
    Thanks.
    JB

  4. Mark 10/28/2008 at 8:15 AM #

    JB,
    Risk of earl;y assignment with OEX options is so large, that I recommend never selling OEX options. It’s just not worth it.
    If you like the better flexibility of the strike choices etc, you can play there. But, you must be extremely careful if any of your short options move ITM by more than just a little bit. Those assignments can hurt.
    I’ve described those risks in a previous post: https://blog.mdwoptions.com/options_for_rookies/european-vs-a-1/
    IMHO, it’s far safer to trade European style index options despite wider bid/ask speads etc.
    I’ve written an article for Investopedia on this topic, but it has not yet been published.
    Mark

  5. Rik 11/01/2008 at 8:05 AM #

    I am trying to understand this example. You said “you must buy 100 shares at the strike price”. If I was short the XZZ NOV 60 call, and my call was exercised, wouldn’t I have to buy the stock at the current market price of $75 (assuming I had sold the call naked) and sell it to the exerciser at $60, losing $1500?
    I realize I would still have the original premium I collected when I sold the call, but that might have been small at the time I sold it.
    What am I missing?
    Thanks

  6. Mark 11/01/2008 at 10:00 AM #

    Mea culpa. You must SELL 100 shares at the strike price. I’ll make the correction.
    But, there seems to still be a misunderstanding of the situation. You are missing the difference between what you MUST do and what you may choose to do.
    When you are assigned on a call option that you sold (uncovered – i.e., you do not own the stock), you MUST sell 100 shares @60 (the strike price). That is the obligation you accepted when you sold the call.
    You are NOT forced to buy stock at the current price. You are allowed to hold a position in which you are short the stock – assuming three things are true:
    1) You have an account that allows short selling
    2) You can meet the margin requirement for holding the short position
    3) You are willing to take the risk of holding the position.
    Most investors/traders refuse to accept the risk and buy 100 shares at the current market price – to cover the short position. But, to answer your question, you have no obligation to do so. The only obligation you have is to deliver (sell) 100 shares. For those shares, you are paid the strike price.
    I apologize for the confusing error.
    Mark

  7. Rik 11/01/2008 at 10:28 AM #

    Ok on that, now, you say “You have lost nothing. You repurchase the call at zero (gaining $1,500”.
    In the real world, when the short call is exercised against me, the exercise results in the short call position being closed automatically and the purchase and sell(delivery) also being part of the automated exercise process. Am I correct? If so, then I don not actually have to take the steps to buy back the short call, and purchase and sell the stock, it is all done, behind the scenes by my broker. Right?
    But as you say, the premium gained on the short option has offset the loss on the stock delivery.
    Is my understanding correct?
    Rik

  8. Mark 11/01/2008 at 10:55 AM #

    Rik, you understand 2/3 of it correctly.
    What is done for you (requiring no action on your part) is (1) the cancellation of the option (most brokers record that transaction at buying it at a cost of zero) and (2) selling stock at the strike price.
    Thus, when you see you account in the morning, you are no longer short the call, but are short stock instead.
    But the third part is NOT done for you – unless there is a margin call and the broker elects to make the trade (buy stock to cover short) automatically. Some brokers issue a margin call and give you time to meet the margin call. Other brokres force the trade as soon as the market opens.
    And that third part is: buying stock to cover the short. That part is not automatic, nor is it required – assuming you can meet the margin requirement to hold the short position.
    It’s usually best to cover that short and eliminate the risk – but that’s your decision and NOT part of the exercise/assignment process.
    In summary, your broker buys the call and sells the stock “behind the scenes.” That’s all. No one buys that stock for you.

  9. Rik 11/01/2008 at 2:05 PM #

    Thanks, very understandable summary of the process.
    I once had a short put on QQQQ get exercised. It was part of an Double Diagonal.
    Found myself sitting on $15,000 worth of QQQQ and owing my broker for it. For a moment I thought I was going to have a heart attack. Then I realized all I needed to do was sell it.
    Being as it was QQQQ it sold in a flash first thing Monday morning. I lost s few bucks but it turned out not to be a big deal. In fact I only sold most of it, kept some which I later sold with enough profit to eventually break even on the whole deal.
    But, for a rookie it was scary for a few moments.
    Thanks again.
    Rik

  10. kumar 10/24/2014 at 1:41 PM #

    Thanks a lot Mark. very clear. it can not be explained more clearer than this. I have my first shorting and your answers above calms few nerves of mine.