Random Assignment of Exercise Notices

Hi Mark,


Some time ago you talked about option sellers getting assigned exercise notices by a
random selection, when an option owner exercised. Let's  say a seller shorted
100 contracts.  Is it right to presume that there is a possibility that the
seller receives a partial assignment, when there is insufficient
exercising buyers to cover the entire 100 contracts?

Thanks

***

Yes,
partial assignments are common. Much less common at expiration.  In your example, there must be a partial assignment.  If fewer than 100 options are exercised, then it's impossible to be assigned on all 100.

For clarity, here's the proper usage for the terms exercise and assignment.

  • An option owner exercises
  • An option seller is assigned

Note: This common mistake:  An option seller is NOT exercised.  He/she is assigned.

The first thing to know is that brokers
are allowed a bit of flexibility in choosing how exercise notices are
handed out (assigned) to clients.  However, they get to select only one
method.  Once chosen the broker is not allowed to change methods.  There
are two basic choices:  random selection (most common) and first
in/first out.

I wrote to the Options Clearing Corporation (OCC) to verify that the system still resembles the way it worked when I was still on the trading floor. (I find it difficult to believe that was ten years ago)  I appreciate their willingness to supply a very useful answer:

"The OCC would put all of the short positions on the wheel — firm by
firm. If firm A has 100 short positions but it lands on position 99,
then that firm gets assigned 2 contracts [#99 and 100] and the next assignment goes to Firm
B.

Typically there are two other random features: the "assignment
quantity" which is typically 25 contracts, and the "skip interval". If
the exerciser exercised 30 contracts, the first 25 would be assigned to
the first 25 open positions and the skip interval would be implemented
— the next 5 contracts would go to the firm(s) with the next 5 short
positions after that interval."

If you are not familiar with the process or some of the terminology, this is how the process works:

Some people exercise a specific option on a given day.

1) The OCC electronically 'spins a wheel.'  On that wheel is every clearing member (your broker, for example) that has at least one customer with a short position in the specific option being assigned notices. NOTE: Long positions held by other clients are ignored. There is no off-set.

2) For each short option, the broker is assigned a space on the wheel.

3) The wheel is spun and stops at a specific firm (firm A in the OCC's example above).  It also stops at a specific option number.  In the example, the firm has an unspecified number of clients who are short a total of 100 options.  If the wheel stops on #99, then the first 98 'escape' being assigned – for the moment.  If all outstanding short options are assigned, the process will go all around the wheel and select those 98 options at the end of the process. 

3) This is one of the reasons why someone may receive a partial assignment

4) The OCC uses an interval.  That means they assign (often 25) notices to 25 consecutive places on the wheel.  Then the 'skip interval' is used to pass over a group of places on the wheel.  After that interval, the process starts again.  It's possible that the assignments go to the same broker, and that broker may still hand them out to the same account.  But it's also possible that the skip interval moves the wheel location to another clearing member.

5) The process is repeated.  Assignments are handed out, the wheel moves, some shorts are bypassed.  When all exercises have been assigned to a clearing member, the process ends.

6) Back to the broker.  There are choices for handing out random assignments.  Each specific option can be randomly assigned.  Or the broker can spin it's own wheel, pick an account and assign as many as possible to that account before selecting another.  It may or may not have a skip interval.

If you ask your broker, my guess is that you will have difficulty finding someone who knows the answer.  It shouldn't really matter to you, as long as the process is truly random.

7) Expiration.  The process is the same at expiration, but usually 100% of all ITM options are exercised.  When an option is slightly ITM (a penny or two), some
options expire worthless (because the owner declined to exercise). The
lucky (or not, depending on your point of view) people who 'slide' (go
unassigned) are the ones who are left over at the end of this assignment
process.

8) So if you are short that 100-lot, you will receive a partial
assignment in these situations:

a) Fewer than 100 contracts are assigned that day

b) The skip interval results in some of your shorts being ignored

c) Your broker's process results in a partial assignment

d) Your broker is firm A in the example, and only a portion of your position is assigned an exercise notice

649


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6 Responses to Random Assignment of Exercise Notices

  1. 5teve 03/26/2010 at 10:21 AM #

    hi, Mark
    I’ve been here for a while, first time to comment something here. I just start to read your newest book ^^.I’ve reading the posts on this blog about kite spread and I like this strategy which i dont see anywhere else. The question is when and how to exit a kite spread, exit part or all of it. Thanks

  2. Mark Wolfinger 03/26/2010 at 1:11 PM #

    Welcome Steve,
    Please feel free to comment/question at any time.
    You don’t see it anywhere else because I coined the term. I don’t know if it will catch on. There is no official nomenclature for option terminology.
    1) If the kite spread is a stand alone bullish or bearish play, I’d suggest exiting in one trade. I would do that at any time you are pleased with the profit. If the market reverses direction those profits can be in jeopardy. Also be aware that these trades are negative theta, so time is the enemy.
    2) You can also do an adjustment to the kite, removing cash when the trade has been profitable. Depending on the strike prices chosen. For example, if you are long the 900 calls and short some 920/930 (or higher strike) call spreads, you can sell the 900/910 call spread to reduce some of the downside risk. If you collect enough cash (say $6, or 60% of the spread maximum), then the upside risk is only hurt by a small amount – and you still have one naked long call to gain from a big move higher.
    I have not yet written about using kite spreads as a stand alone play.
    If it was an adjustment, then you want to be certain that you don’t leave yourself with a risky position after exiting.

  3. 5teve 03/27/2010 at 7:07 PM #

    Hi, Mark
    Thanks for your answer. Sorry I didn’t make it clear on my question that: when and how to exit a kite spread (when using as insurance for iron condor)? perhaps I miss that on one of your posts about kite spread, did I?Thanks

  4. 5teve 03/27/2010 at 7:42 PM #

    Hi, Mark
    In addition, do you consider a debit spread as an insurance for a credit spread when its short strike near the money? thanks

  5. Mark Wolfinger 03/28/2010 at 7:39 AM #

    See this post for some ideas.
    If you need the protection, you cannot exit. But you can adjust, remove some cash and still have sufficient protection – especially for the huge move.
    But – if you manage the iron condor as its own entity and exit or significantly reduce the size, then the kite is no longer needed, and should be sold. In this scenario you will have a loss from the IC and a profit from the kite. Your overall gain/loss depends on how many kites you own.
    Warning: Don’t by so many kites that you always have a profit in this situation because it’s too costly and a market reversal will hurt.

  6. Mark Wolfinger 03/28/2010 at 7:45 AM #

    Yes, with some big BUTS:
    1) The potential profit from a debit spread is limited and won’t do much good on a significant move.
    2) To me, this is the worst possible adjustment. Remember that buying a call spread to protect other call spreads is equivalent to selling a put spread.
    Thus, when a call spread gets into trouble, some traders prefer to sell put spreads as protection. If the market reverses, you are suddenly exposed to big losses. And those losses are due to having sold the put spreads (or the equivalent, buying call spreads).
    3) This looks good. It’s less expensive than other plays. When you sell the put spread, you take in more cash. It just looks good. But, it’s not good.
    I usually suggest a trader use any reasonable play that suits his/her comfort zone. Not this one. I don’t like this one at all.
    It’s too risky and I seriously advise against this play.