One special feature of options is that they can be turned into shares of an option’s underlying security. This happens when the option holder (buyer) chooses to exercise his option contract. An option writer (seller) of this exact option contract is then required to deliver the given number of stock of the underlying asset. This is only the case for stocks. Index options are settled through cash. This means that you will have to pay the price difference if someone chooses to exercise your index option. This process is called assignment. Many option traders are unaware of how this procedure works and therefore don’t know how to handle it and what to do when they get assigned. This topic is especially of relevance in the option trading style I teach here (option premium selling). In the following article, I will try to walk you through an assignment process with a put option.
How does Assignment work
When someone chooses to exercise his option contract, the broker sends this request to the OCC (Options Clearing Corporation). They then immediately send the requested shares back to the broker who delivers them to the exerciser. To get their money back the OCC then picks another broker at random which gets assigned these shares. The broker will randomly select a seller or more than one of exactly this option to deliver the shares back to the OCC. If the broker chooses you for assignment, your broker will notify you and deliver the shares to your account. After this, you will immediately be able to sell the shares back to the market.
Should you be worried about getting assigned – When will you be assigned?
First of all, it is pretty safe to say that you won’t get assigned very often. Generally, options don’t get exercised too often. This is because there aren’t too many reasons to exercise an option. Many option traders just trade options for profit and not for the shares of stock. Even though there are options which can theoretically be exercised before expiration (American options) there is no real reason to do so. This is because when an option is exercised you’ll make as much profit as the option is ITM, so only the intrinsic value. But the option doesn’t only consist of intrinsic value. The price of an option also contains the extrinsic value. This means if there is time left until expiration or a change in volatility, it is more profitable to sell the option than to exercise it. The only reasons why people would exercise their option instead of selling it before expiration would be:
1. It is very deep ITM/almost no time left (so only very little extrinsic value)
2. There are high commissions for selling the option and then buying shares and it is, therefore, more profitable to exercise.
Because of this, most assignments take place in the last week before expiration. Statistically speaking over 80% of assignments take place in the last week of an expiration cycle. You usually should be safe from any assignments as long as there is enough time left until expiration. But sometimes there are exceptions where you can get assigned earlier on. Even if you get assigned, you won’t really lose much more money than if the option had expired ITM (without assignment). The only problem with assignment is that it can be capital intensive because you have to hold 100 shares of the underlying and sometimes you’ll have to free some capital by closing out other positions or through other methods. But generally speaking you shouldn’t be too concerned about getting assigned because it happens rarely and if it happens it’s no huge deal either.
What happens if you don’t have enough capital in your account to ‘handle’ an assignment?
If you don’t have enough capital to cover an assignment, your account balance will become negative and you will receive a margin call. This means that you have a certain period of time to free enough money to cover this call (often around 1 week). This can be done by closing other positions or depositing some cash. If you have to buy stock (your short put gets exercised), I always recommend closing/selling these shares as soon as possible to minimize exposure and return closer to your old account balance.
How to minimize Assignment Risk
The first thing you should do to minimize assignment risk is to close out any losing positions until expiration. You should probably try to close them out before the expiration week begins. Otherwise, you generally shouldn’t hold on to very deep ITM options (for American options). These are the most likely to get exercised and should be closed out to avoid assignment. Another thing which would reduce the risk of an assignment is not to trade options on securities with upcoming dividends. These get exercised more often than other options.
One thing which would help in case of an assignment is to always keep a certain percentage of your trading account or other capital in cash so you won’t be required to close out positions when having to allocate money in this relatively small time frame. Nowadays some brokers even close out your option positions automatically in times of high assignment risk. You should definitely find out if your broker does this or not. Many brokers handle assignment differently. Therefore, I would advise you to check how your broker handles assignments exactly.
This Article is part of the Advanced Option Trading Course. If you are reading the article as a part of the course, you can continue to the next lesson: HERE