Understanding Options Assignment: What It Means and How to Respond
Understanding Options Assignment: What It Means and How to Respond
Anyone who trades options needs to understand assignments.
Even when you buy a call or put option, you can still be assigned long or short positions on a stock. Sometimes you want this. Sometimes you don't.
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Getting assigned shares is part of his strategy. He and his members know what to do if and when this happens.
But sometimes — if you're trading strictly to gather premium — you can have your options contract exercised and shares assigned when you don't want that to happen.
We're going to dive into what an options assignment is, how to avoid it, and what to do when it happens.
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Before we begin, I want to provide a few definitions to guide you in this article:
Exercise — When an option contract is executed by the option buyer.
Assignment — What happens to shares of an option contract. As an option seller, you can be assigned 100 long shares of stock per put option contract and 100 short shares of stock per call option.
Call Option — Gives the owner the right to call (buy) shares from the option seller.
Put Option — Gives the owner the right to put (sell) shares to the option seller.
Short Option — Selling an option contract.
Long Option — Buying an option contract.
A Cautionary Tale
I want to share a brief story about option assignments to help you understand the danger of having an option you sold get exercised.
Nikola, helmed by the charismatic CEO Trevor Milton, is an electric-vehicle startup that inked a partnership with General Motors (GM) in September 2020.
In June 2020, shares of Nikola (NKLA) peaked at $93.99.
But by July 20 of that year, the stock plummeted after the company announced plans to sell nearly 24 million shares, and people scrambled to short it.
There were so few shares available to trade that they were incredibly hard to borrow. Typically, when you short shares of a stock, you pay a minuscule cost to borrow them from your broker.
However, the fees to short shares of Nikola cost $1 per share per day! (The cost of borrowing a stock to short can vary, but typically ranges from 0.3% to 3% per year.)
Consequently, options markets went haywire.
Instead of shorting the stock, traders bought put options to avoid the fees, making them extremely expensive relative to call options because demand for puts skyrocketed.
However, some options traders figured out that they could make bearish bets on the stock by selling a call credit spread.
By selling an out-of-the-money call at a strike price that was higher than the stock's current price and then buying another call at a higher strike price than the first, they would collect a credit. All they had to do was wait until expiration, and as long as the share price stayed below both strike prices, the options would expire worthless and the trader would get to keep the credit.
However, something unusual happened.
You see, option owners rarely exercise their rights to assign long or short positions unless the options are in the money and near expiration.
I mean, why would you exercise a call option to buy shares of Nikola at $60 when it trades at $55 in the open market?
Except that's exactly what happened because traders couldn't get ahold of the shares. These option holders were exercising contracts to take ownership of long stock that they could then loan out to short-sellers at $1 per share per day.
Traders who sold a call credit spread on Nikola were waking up to find that even though the call option they sold was out of the money, the option had been exercised and they had been assigned short shares of Nikola.
And guess what? Since each option contract controls 100 shares of stock, at $1 per share per day in borrowing costs, that trader was losing $100 for every call option contract that was exercised for every day the position remained open.
Typically, if you sell a call credit spread that goes in the money (not what you want), meaning the stock trades above the strike prices of both the call option you sell and the call option you buy, your broker exercises the long option to offset the assignment of the short option, leaving you with zero shares short.
However, that didn't happen here because the options were out of the money. So you had to call your broker to exercise the other option, which may or may not have happened. Nor was it just as simple as buying shares in the open market. That also took time.
Traders who didn't understand the nuances of options assignment lost a lot of money.
This is a very rare and unusual situation. But it can and does happen.
What Is Option Assignment?
Assignment occurs when the option buyer decides to exercise the contract, requiring the seller to buy (call) or sell (put) the shares of stock covered by the contract.
If I sold you a call option on Apple (AAPL) with a strike price of $100, you wouldn't want to exercise that contract unless Apple traded above $100 per share. Otherwise, you'd be buying shares of Apple above the current market price.
Similarly, if you bought a put option on Apple (AAPL) with a strike price of $100, you wouldn't want to exercise that contract unless Apple traded below $100 per share. Otherwise, you'd be selling shares of Apple below the current market price.
When a call option contract is exercised, the seller of the call contract is required (assigned) to sell 100 shares of stock per option contract to the option buyer.
If I own 100 shares of Apple and one call option contract I sold is exercised, I would be forced to sell to the owner of that call contract the 100 shares of stock that I owned.
This is what's known as a covered call.
If I didn't own any shares of the stock, my broker would short 100 shares of stock per option contract assigned on my behalf.
The good news is that when I sold someone that call option contract, I received a credit known as the premium, which I get to keep.
When a put option contract is exercised, the seller of the put contract is required (assigned) to buy 100 shares of long stock per option contract.
Let's say I sold one put option contract and was already short 100 shares of stock. If the purchaser of that put option contract exercised the option, they would assign me 100 shares of stock, which would offset my 100 shares of short stock.
Again, I would still be able to keep the option premium I received when I sold the put contract.
Now, if I wasn't already short shares of a stock, when a put option I sold is exercised, I would be forced to buy 100 shares of stock per option contract.
Assuming I set aside enough cash to do this and don't borrow anything on margin, this is known as a cash-secured put.
Handling Assignment
There are times when I want to be assigned shares of stock, or at least I don't mind getting assigned. For example, if I sell a cash-secured put on Apple at the $75 strike price, should Apple drop below $75 and I am assigned 100 shares of Apple stock per option contract, I'm more than happy to own Apple's stock at that price. Plus, I get to keep the premium for selling that option.
However, that's not always the case.
If you ever find yourself in a position where you have been assigned long or short shares of stock when you didn't want that to happen, there is only one thing you should do: Exit the position immediately.
If you are assigned shares of short stock, buy them back to close the position.
If you are assigned shares of long stock, sell them to close the position.
I don't want to say that you should never do anything else, but it's exceedingly rare not to immediately close the position.
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First, remember that you only need to worry about an option contract getting exercised before expiration if you sold the contract. This cannot happen with a long option unless you've instructed your broker to exercise the option contract.
Now, most short option contracts will not be exercised unless:
The option is deep in the money, even if there is a lot of time until the expiration date
The option is in the money and it is near or at expiration
So how do you avoid having an option you sold get exercised?
Close out the position before expiration.
If an option you sold goes deep in the money, even if there is plenty of time left until expiration, close it out. You can use the +/- 0.8 delta as your line in the sand when deciding whether to close out an in-the-money option.
Otherwise, close out any option that is in the money, at the money, or close to at the money before expiration.
That means you can do it the day of expiration or a few days before.
There isn't a hard-and-fast rule as to when to do it. It all depends on what the goal of your trade is. If your trade is only going to last a week, then you'll want to squeeze as much out of it as you can and wait until the last day to close the trade. However, if you've been in the trade for weeks, you can close your trade out a few days from expiration.
Final Thoughts
The majority of the time, you do not want any short option to go to expiration even when it's far out of the money.
Simply put, the few extra dollars you'd make are not worth the risk that there could be a massive market move during the last few days that would flip your trade from profit to loss.
Although I covered the most important points of options assignment, what other questions can I help you with? Have you ever had an option contract exercised when you didn't expect it?
While I can't answer each of you individually, I promise to read every email.
Enjoy your Tuesday,
Keith Kaplan CEO, TradeSmith
P.S. If option assignments weren't previously on your radar, just think of what other techniques you aren't aware of that could put thousands of dollars in your account every week!
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TradeSmith is not registered as an investment adviser and operates under the publishers' exemption of the Investment Advisers Act of 1940. The investments and strategies discussed in TradeSmith's content do not constitute personalized investment advice. Any trading or investment decisions you take are in reliance on your own analysis and judgment and not in reliance on TradeSmith. There are risks inherent in investing and past investment performance is not indicative of future results.
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