Risks of Options Assignment

Any trader holding a short options position should understand the risks of early assignment. An early assignment occurs when a trader is automatically required to buy or sell stock when the short option is exercised by the long option holder. Understanding how assignment works can potentially help traders take steps to reduce losses. It's important to remember short American-style options can be assigned at any time up to expiration regardless of the in-the-money (ITM) amount. An ITM option has a higher risk of being assigned early.

An options contract gives the owner the right, but not the obligation, to buy or sell an underlying stock at a predetermined price on or before a specific date. An assignment obligates an option seller to fulfill the terms of the contract. 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—if American-style options settlement applies. 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.

There are two components to the price of an option: intrinsic and extrinsic value. In the case of exercising an  ITM long call, a trader would buy the stock at the strike price, which is lower than its prevailing price. In the case of exercising a long put that isn't being used as a hedge for a long stock position, the trader would short the stock for a price higher than its prevailing price. A trader only captures the intrinsic value of ITM options 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 shorted. One way to attempt to gauge the likelihood an option might be assigned is to consider the associated dividend. An option seller might be more likely to get assigned on a short call prior to an upcoming ex-dividend date 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 tab of the thinkorswim^® 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 guarantee future results, this information can help a trader determine whether assignment is more or less likely.

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, which would essentially flatten out the position.

A trader with a call vertical spread 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 in order to have the long stock on hand to deliver against the potential assignment of the short call. However, keep in mind that converting the long option into shares would require significant capital. 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 should they be assigned.

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, taking liquidity into consideration. On the ex-dividend date, the stock price typically drops by roughly the same amount of the cash dividend.

When an option is converted to stock through exercise or assignment, the position's risk profile changes. This change could increase the margin requirements, subject a trader to a margin call, or both. This can happen on or before expiration during early assignment.