Any trader holding a short option position should understand the risks of early assignment. An early assignment occurs when a trader is forced to buy or sell stock when the short option is exercised by the long option holder. Understanding how assignment works can help a trader take steps to reduce their potential losses.
Understanding the basics of assignment
An option gives the owner the right but not the obligation to buy or sell stock at a set price. An assignment forces the short options seller to take action. Here are the main actions that can result from an assignment notice:
- Short call assignment: The option seller must sell shares of the underlying stock at the strike price.
- Short put assignment: The option seller must buy shares of the underlying stock at the strike price.
For traders with long options positions, it's possible to choose to exercise the option, buying or selling according to the contract before it expires. With a long call exercise, shares of the underlying stock are bought at the strike price while a long put exercise results in selling shares of the underlying stock at the strike price.
When a trader might get assigned
There are two components to the price of an option: intrinsic1 and extrinsic2 value. In the case of exercising an in-the-money3 (ITM) long call, a trader would buy the stock at the strike price, which is lower than its prevailing price. In the case of a long put that isn't being used as a hedge for a long stock position, the trader shorts the stock for a price higher than its prevailing price. A trader only captures an ITM option's intrinsic value if they sell the stock (after exercising a long call) or buy the stock (after exercising a long put) immediately upon exercise.
Without taking these actions, a trader takes on the risks associated with holding a long or short stock position. The question of whether a short option might be assigned depends on if there's a perceived benefit to a trader exercising a long option that another trader has short. One way to attempt to gauge if an option could be potentially assigned is to consider the associated dividend. An options seller might be more likely to get assigned on a short call for an upcoming ex-dividend if its time value is less than the dividend. It's more likely to get assigned holding a short put if the time value has mostly decayed or if the put is deep ITM and close to expiration with a wide bid/ask spread on the stock.
It's possible to view this information on the Trade page of the thinkorswim® trading platform. Review past dividends, the price of the short call, and the price of the put at the call's strike price. While past performance cannot be relied upon to continue, this information can help a trader determine whether assignment is more or less likely.
Reducing the risk associated with assignment
If a trader has a covered call that's ITM and it's assigned, the trader will deliver the long stock out of their account to cover the assignment.
A trader with a call vertical spread4 where both options are ITM and the ex-dividend date is approaching may want to exercise the long option component before the ex-dividend date to have long stock to deliver against the potential assignment of the short call. The trader could also close the ITM call vertical spread before the ex-dividend date. It might be cheaper to pay the fees to close the trade.
Another scenario is a call vertical spread where the ITM option is short and the out-of-the-money (OTM) option is long. In this case, the trader may consider closing the position or rolling it to a further expiration before the ex-dividend date. This move can possibly help the trader avoid having short stock on the ex-dividend date and being liable for the dividend.
Depending on the situation, a trader long an ITM call might decide it's better to close the trade ahead of the ex-dividend date. On the ex-dividend date, the price of the stock drops by the amount of the dividend. The drop in the stock price offsets what a trader would've earned on the dividend and there would still be fees on top of the price of the put.
Assess the risk
When an option is converted to stock through exercise or assignment, the position's risk profile changes. This change could increase the margin requirements, or subject a trader to a margin call,5 or both. This can happen at or before expiration during early assignment. The exercise of a long option position can be more likely to trigger a margin call since naked short option trades typically carry substantial margin requirements.
Even with early exercise, a trader can still be assigned on a short option any time prior to the option's expiration.
1 The intrinsic value of an options contract is determined based on whether it's in the money if it were to be exercised immediately. It is a measure of the strike price as compared to the underlying security's market price. For a call option, the strike price should be lower than the underlying's market price to have intrinsic value. For a put option the strike price should be higher than underlying's market price to have intrinsic value.
2 The extrinsic value of an options contract is determined by factors other than the price of the underlying security, such as the dividend rate of the underlying, time remaining on the contract, and the volatility of the underlying. Sometimes it's referred to as the time value or premium value.
3 Describes an option with intrinsic value (not just time value). A call option is in the money (ITM) if the underlying asset's price is above the strike price. A put option is ITM if the underlying asset's price is below the strike price. For calls, it's any strike lower than the price of the underlying asset. For puts, it's any strike that's higher.
4 The simultaneous purchase of one call option and sale of another call option at a different strike price, in the same underlying, in the same expiration month.
5 A margin call is issued when the account value drops below the maintenance requirements on a security or securities due to a drop in the market value of a security or when buying power is exceeded. Margin calls may be met by depositing funds, selling stock, or depositing securities. A broker may forcibly liquidate all or part of the account without prior notice, regardless of intent to satisfy a margin call, in the interests of both parties.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any options transaction. Supporting documentation for any claims or statistical information is available upon request.
With long options, investors may lose 100% of funds invested.
Spread trading must be done in a margin account.
Multiple leg options strategies will involve multiple commissions.
Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.0923-3KSF