Exercise and Assignment. Not to worry

The exercise/assignment process is straightforward, easy to understand, and is experienced by almost every option trader at one time or another. 

An option is a contract in which the writer (seller) promises that any buyer has the right  to buy or sell the underlying asset at the strike price on or before a specific date.

Electing to buy or sell the underlying (per the contract) is referred to as 'exercising.'  Being notified that the exercise has been assigned to your account is referred to as an 'assignment.'

Unfortunately, many new traders become overly worried about the process because they  don't bother to pay attention to the rules regarding how the process works. Why would anyone trade an option without being aware that it's possible to be assigned early?  When we drive a car, we are supposed to learn the rules of the road.  Traders who don't take the time to understand what they are trading are flying blind.

I've discussed this topic many times (here's the first), and you can search (below) for Exercise and assignment to read some of the posts.


Free put, free call

Why beginner's fear being assigned an exercise notice is beyond my comprehension.   When anyone sells an option, he/she is accepting an obligation to be assigned.  So why is it it so unsettling to be assigned one of those exercise notices prior to expiration?

Being assigned an exercise notice turns a short call option into short stock.  So what?  That exercise is equivalent to giving the option seller a free put [same strike and same expiration as the option being assigned].

Being assigned an exercise notice on a put option does cost a bit of cash (in carrying costs), but it is equivalent to being given a free call.

It's unlikely that these free options will be worth anything, but every once in awhile lightning strikes and I love  being handed those free puts and calls.  Unless it results in a margin call, being assigned early is not a problem.  If it does result in a margin call, you are probably trading too many contracts for the size of your account.

 

European and American style options

European style options cannot be exercised prior to expiration.  If you absolutely cannot tolerate being assigned early, it may pay to trade European style options.  However, there are far more important items that differ between American and European style options that it's crucial to understand these differences before attempting to trade them.  this is not an idle warning.

To read more about these differences, search (below) for American vs. European options

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4 Responses to Exercise and Assignment. Not to worry

  1. Roberto 10/21/2010 at 2:24 PM #

    Hi Mark,this is Roberto from Italy;
    What do you think about Tljs, and in general, volatility trading?
    Do you use Tljs in your portfolio?
    Thanks
    Rob

  2. Mark Wolfinger 10/21/2010 at 8:43 PM #

    Roberto,
    I don’t know what Tljs are.
    Volatility trading is an important method for traders. It involves strategiesa that are more complicated that the methods I discuss on this blog.
    However, I wanta ato emphasize that ‘volatility trading’ is more than buying positions with positive vega and hoping that IV will increase.
    I do not use it myself. I am spending less and less time trading and devoting more and more time to the blog. Hence, I keep my trading as simple as possible.

  3. Mike 10/21/2010 at 10:41 PM #

    Mark, thanks for revisiting this topic. What if I want to buy and sell calls but don’t want to sell my current shares. Is there anyway to avoid this? So it means that you’re selling shares or giving the right to buy, but not the obligation to buy your shares? And also, if I am selling covered calls, and the stock hits the strike price, isn’t it almost a given that the stock will be called away from me and sold at the strike price?
    Mike

  4. Mark Wolfinger 10/21/2010 at 10:58 PM #

    Mike,
    1) If the stock hits the strike price, it is not only not a given – it is virtually a guarantee – that you will NOT be assigned an exercise notice and your shares will not be ‘called away’
    Do you want proof? Look at any stock that is above the strike price of a given call option. Look at the open interest for that option. Is that OI anywhere near zero? Does it look as if everyone who was long that option exercised?
    Look at the price of the option. Isn’t it price far above it’s intrinsic value? Don’t you understand that if the option were exercised the owner would lose every penny of that time premium?
    2) The option will only (with occasional exceptions) be exercised when expiration arrives and when the stock price is above the strike price.
    Please, write back and tell me that you understand this to be true. Please.
    Here’s another piece of harsh advice: If you do not understand every word of the explanation above you have no business trading options. You have no idea how options work and have zero chance – outside of good luck – to earn any money.
    Learn the basics. Then trade.
    3) I ask a favor: Where did you get the idea that the option would be exercised under the conditions stated?
    4) Yes, there is a way to avoid selling the stock. One simple method is to hold the long stock shares in a different account. Then if you are assigned an exercsie notice you will still own the shares and simply be short shares in the other account. You can repurchase those shares whenever you want to do so.