Investment Tips 22-02-2023 03:08 30 Views

Everything You Need to Know About Options Assignment Risk

But in this article, we're going to show you why early assignment is a vastly overblown fear, why it's not the end of the world, and what to do if it does occur.

 

What is Assignment in Options Trading?

Do you remember reading beginner options articles or books that said, "an option gives the buyer the right, but not the obligation, to buy/sell a stock at a specified price and date?" Well, it's accurate, but only for the buy side of the contract.

 

The seller of an option is actually obligated to buy or sell should the buyer choose to exercise their contract. So when options, assignment is when you, the lucky seller of an options contract, get chosen to make good on your obligation to buy or sell the underlying asset.

 

Let's say you sold a call option on a stock with a strike price of $50, which you held until expiration. At expiration, the stock trades at $55, meaning it's automatically exercised by the buyer. In this case, you are forced to sell the buyer 100 shares at $50 per share.

 

So when selling options, assignment is when you, the lucky seller of an options contract, get chosen to make good on your obligation to buy or sell the underlying asset.

 

What is Early Assignment in Options Trading?

Early assignment is when the buyer of an options contract that you're short decides to exercise the option before the expiration and begins the assignment process.

 

Many beginning traders count early assignments as one of their biggest trading fears. Many traders' fear of early assignment stems from their lack of understanding of the process. Still, it's typically not something to worry about, and we'll show you why in this article. But first, let's look at an example of how the process works.

 

For instance, say we collect $1 in premium to short a 30-day put option on XYZ with a strike price of $45 while the underlying is trading at $50. Fast forward, and it's the morning of expiration day. Options will expire at the close of trading in a few hours. The underlying stock is hovering around $44.85. Our plan pretty much worked as planned until, for some reason, the holder of the option exercises the option. We're confused and don't know what's going on.

 

It works exactly the same way as ordinary settlement. You fulfill your end of the bargain. As the seller of a put option, you sold the right to sell XYZ at $45. The option buyer exercised that right and sold his shares to you at $45 per share.

 

And now, let's break down what happened in this transaction:

  • You collected $1 in premium when opening the contract
     
  • The buyer of the option exercises his right to sell at $45 per share.
     
  • You’re now long 100 shares of XYZ that you paid $45 for, and you sell them at the market price of $44.80 per share, realizing a $0.20 per share loss.
     
  • Your profit on the transaction is $0.80 because you pocketed $1 from the initial sale of the option but lost $0.20 from selling the 100 shares from assignment at a loss.

 

Why Early Assignment is Nothing to Fear

Many beginning traders count early assignments as one of their biggest trading fears; on some level, it makes sense. As the seller of an option, you're accepting the burden of a legitimate obligation to your counterparty in exchange for a premium. You're giving up control, and the early assignment shoe can, on paper, drop at any time.

 

Exercising Options Early Burns Money

People rarely exercise options early because it simply doesn't make financial sense. By exercising an option, you're only capturing the option's intrinsic value and entirely forfeiting the extrinsic value to the option seller. There's seldom a reason to do this.

 

Let's put ourselves in the buyer's shoes. For instance, we pay $5 for a 30-day call with a strike price of $100 while the underlying is trading at $102. The call has $2 in intrinsic value, meaning our call is in-the-money by $2, which would be our profit if the option expired today.

 

The other $3 of the option price is extrinsic value. This is the value of time, volatility, and convexity. By exercising early, the buyer of an option is burning that $3 of extrinsic value just to lock in the $2 profit.

 

A much better alternative would be to sell the option and go and buy 100 shares of the stock in the open market.

 

Viewed in this light, an option seller can’t be blamed for looking at early assignment as a good thing, as they get to lock in their premium as profit.

 

Your Risk Doesn’t Change

One of the biggest worries about early assignment is that being assigned will somehow open the trader up to additional risk. For instance, if you’re assigned on a short call position, you’ll end up holding a short position in the underlying stock.

 

However, let me prove that the maximum risk in your positions stays the same due to early assignment.

 

How Early Assignment Doesn’t Change Your Position’s Maximum Risk

Perhaps you collect $2.00 in premium for shorting an ABC $50/$55 bear call spread. In other words, we're short the $50 call for a credit of $2.50 and long the $55 call, paying a debit of $0.50.

 

Before considering early assignment, let's determine our maximum risk on this call spread. The maximum risk for a bear call spread is the difference between the strike minus the net credit you receive. In this case, the difference between the strikes is $5, and we collect a net credit of $2, making our maximum risk on the position $3 or $300.

 

You wake up one morning with the underlying trading at $58 to find that the counterparty of your short $50 call has exercised its option, giving them the right to buy the underlying stock at $50 per share.

 

You'd end up short due to being forced to sell the buyer shares at $50. So you're short 100 shares of ABC with a cost basis of $50 per share. On that position, your P&L is -$800, the P&L on a $55 long call is +$250, on account of you paying $0.50, and the call being $3.00 in-the-money. And finally, because the option holder exercised early, you get to keep the entire credit you collected to sell the $50 call, so you've collected +$250.

 

So your P&L is $300. You've reached your max loss. Let's get extreme here. Suppose the price of the underlying runs to $100. Here are the P&Ls for each leg of the trade:

  • Short stock: -$5,000
     
  • Long call: +$4,450
     
  • Net credit received from exercised short option: +$250
     
  • 5,000 - (4,450 + 250) = $300

 

While dealing with early assignments might be a hassle, it doesn’t open a trader up to additional risk they didn’t sign up for.

 

Margin Calls Usually Aren’t The End of the World

Getting a margin call due to early assignment isn't the end of the world. Believe it or not, stock brokerages have been around for a long time. They have seen early assignments many times before, and they have protocols for it.

 

Think about it intuitively, your broker allowed you to open the short option position knowing that the capital in your account could not cover an early assignment. Still, they let you make the trade anyways.

 

So what happens when you get an early assignment that you can’t cover? Your broker issues you a margin call. Once you’re in violation of their margin rules, they pretty much have carte blanche to handle the situation as they wish, including liquidating the assigned stock position at their will.

 

However, most brokers will give you some time to react to the situation and either decide to deposit more capital, liquidate the position on your own, or exercise offsetting options to fulfill the margin call in the case of an option spread.

 

Even though a margin call isn't fun, remember that the overall risk of your position doesn't change due to an early assignment, and it's typically not a momentous event to deal with. You probably just have to liquidate the trade.


When Early Assignment Might Occur?

 

Dividend Capture

One of the few times it might make sense for a trader to exercise an option early is when he's holding a call that is deep in-the-money, and there's an upcoming ex-dividend date.

 

Because deep ITM calls have very little extrinsic value (because their deltas are so high), any negligible extrinsic value is often outweighed by the value of an upcoming dividend payment, so it makes sense to exercise and collect the dividend.

 

Deep In-The-Money Options Near Expiration

While it's important to emphasize that the risk of early assignment is very low in most cases, the likelihood does rise when you're dealing with options with very little extrinsic value, like deep-in-the-money options. Although, even in those cases, the probabilities are pretty low.

 

However, an options trader that is trading to exploit market anomalies like the volatility risk premium, in which implied volatility tends to be overpriced, shouldn't even be trading deep-in-the-money options anyhow. Profitable option sellers tend to sell options with very little intrinsic value and tons of extrinsic value.

 

Bottom Line

Don't let the fear of early assignment discourage you from selling options. Far worse things when shorting options! While it's true that early assignment can occur, it's typically not a big deal.

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