Q & A. Trading Options: Exercise and Assignment

Via email: "Would like more on the perils of assignment."

One of the recurring topics I encounter is a  new option trader's concern about being assigned an exercise notice on some option he/she has sold.

There are situations in which being assigned results in an unhappy ending, but they are few are far between.

Let's begin with simple definitions for option rookies:

Exercise: The process by which an option owner does what the option contract allows.  The call owner buys 100 shares of the underlying asset by paying the strike price. [NOTE: if the option is European style, the call owner may only exercise when expiration arrives and receives the intrinsic value of the option, in cash]

Assignment: The process by which an investor who has a short position (the option has been sold, but not yet expired or repurchased) in a specific option is notified by his/her broker that the OCC (Options Clearing Corporation) has issued an assignment notice and that the broker has designated the investor's account (randomly selected) to receive that notice.  The investor is now required to fulfill the conditions of the option contract by selling (if it is a call) or buying (if it is a put option) 100 shares of the underlying asset at the strike price.  The assignment notice is irrevocable.

If you have a position and receive such a notice, what can go wrong?  All that has happened to you is that an option has been converted to stock.  Unless you are trading in a small account and receive a margin call, you are now in better shape (risk-wise) than you were before being assigned.

If you wrote a covered call, the position has been closed, you earned the maximum possible profit from the trade and you received cash that allows you to make a new trade.

If you wrote a naked put, you now own the shares you were willing to buy when you sold the put.  No harm done, if you truly want to own the shares.

If you have a complex position, an option with 100 delta has been removed from your account and been replaced with stock.  If there are no margin problems, then this position has a better risk profile than you had before you were assigned.  I don't want to take the space for the details, but look at it this way:  If short a call, all you make on a decline is the call premium.  But if you are short stock as the result of an assignment, and the stock tumbles below the strike price, you earn more than you could have earned before.  In effect, the option you sold is now trading at less than zero.  How can that be bad for you?

There is one very troublesome situation, and that occurs when you sell American style index options.  That applies only to OEX options, so to avoid this problem, don't trade OEX options (they are ok to purchase if you are an option buyer, but don't sell them). A detailed explanation of why this type of assignment can cause problems is presented in this Investopedia article.

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