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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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