Assignment risk refers to the possibility that an options trader may be required to fulfill the terms of an options contract, typically involving the purchase or sale of the underlying asset before the expiration date.
Before diving into assignments, it's essential to grasp the basics of an option agreement and what it means to buy or sell an options contract. This guide will explain the agreement between buyer and seller, what an assignment is, why it happens, its implications, and how traders can manage assignments.
THE OPTION AGREEMENT:
Option Buyer - gives the individual the right, but not obligation, to buy or sell an underlying asset at a specified price within a certain period of time before the option’s expiration date.
-
This includes the purchase of:
-
Call Options
-
Put Options
-
-
The option buyer pays a premium debit to the option seller in exchange for this right and if the market moves in the buyer’s favor, they can exercise the option to either buy or sell the underlying asset at a more significant price.
Option Seller - otherwise known as an option writer, is an individual who sells an options contract to a potential buyer. The seller is then obligated to fulfill the terms of the contract if the buyer decides to exercise the option.
-
This includes the sale of:
-
Call Options
-
Put Options
-
-
In return for taking on this obligation, the option seller receives a premium from the buyer and if the market moves in the seller’s favor, thus the seller makes profit and the buyer loses since it is not favorable for the buyer to exercise the option.
STATUS | TYPE OF OPTION | AGREED TERMS |
Buyer (Holder) | Call Options | - Purchases a call option, paying a premium to the seller.
- Gains the right, but not the obligation, to buy the underlying asset at the strike price within a set time frame.
- Can exercise the option to buy the asset at the lower strike price if the market price rises above the strike price.
- Can let the option expire, losing only the premium paid, if the market price does not exceed the strike price. |
Seller (Writer) | Call Options | - Writes a call option and receives the premium from the buyer.
|
Buyer (Holder) | Put Options | - Purchases a put option, paying a premium to the seller.
- Gains the right, but not the obligation, to sell the underlying asset at the strike price within a set time frame.
- Can exercise the option to sell the asset at the higher strike price if the market price falls below the strike price.
- Can let the option expire, losing only the premium paid, if the market price does not fall below the strike price. |
Seller (Writer) | Put Options | - Writes a put option and receives the premium from the buyer.
|
WHAT IS AN OPTION ASSIGNMENT?
Option Assignment is the potential obligation of the option seller (writer) to purchase or sell the underlying stock at the option’s strike price when the option is exercised by the holder (buyer) of the long position. [1][2][3][4]
-
Short put assignment can occur when the seller of the option contract is obligated to buy shares of the underlying stock at the strike price of the option.
-
Short call assignment can occur when the seller of the option contract is obligated to sell shares of the underlying stock at the strike price of the option.
WHY DOES OPTION ASSIGNMENT OCCUR?
Option assignment can occur for various reasons explained by the motive of the holder (buyer).
-
Here are a few motivating factors:
-
Profit Motive: If an option is in-the-money (ITM), exercising it can result in a profit for the holder (buyer).
-
Automatic Exercise: Many brokers automatically exercise ITM options at expiration if the option is at least one cent ITM.
-
Dividend Capture: Call option holders might decide to exercise their options early to capture a dividend payment.
-
Risk Management: The option holder may decide to exercise to reposition their portfolio.
-
WHEN CAN OPTION ASSIGNMENT OCCUR?
-
Option Assignment Occurrence can happen anytime on or prior to the expiration date. Although the option can be assigned anytime, it must be in-the-money for the owner/buyer to benefit from exercising their right to buy or sell shares of stock or options. [1]
-
European-style options that are being sold cannot be assigned since their option can only be exercised on the expiration date.
-
American-style options that are being sold can be assigned at any time since their option can be exercised at any time prior to the expiration date.
-
-
Automatic Option Assignment occurs automatically if it is In-the-money on the expiration date. [1]
-
Random Option Assignment can occur anytime prior to the expiration date and your short option position is In-the-money.
-
The OCC (Options Clearing Corporation) ensures that the assignment process is done at random when a buyer exercises their option. [3][4]
-
WHAT DO I DO IF I GET ASSIGNED?
-
If Assigned on a Call Option you will be obligated to sell the underlying stock at the strike price to the option holder (buyer).
-
If the position you hold is a covered call, the shares will be sold from your account.
-
If you don’t own the stock, you will need to buy the shares at the current market price to deliver them, potentially incurring a loss if the market price is higher than the strike price.
-
-
If Assigned on a Put Option you will be obligated to buy the underlying stock at the strike price from the option holder (buyer).
-
If the current market price is lower than the strike price, then you will buy the stock at a higher price, potentially incurring a loss.
-
If you don’t have sufficient funds in your account to cover the purchase depending on your brokerage you may be left in a deficit. If this is the case you are left with three options:
-
Sell the purchased shares at market open to cover the deficit.
-
Deposit funds into your account to cover the deficit and keep the shares.
-
Keep the shares and open another position like a covered call.
-
-
HOW DO I PREVENT OPTION ASSIGNMENT?
Avoiding Assignment is not entirely avoidable but is less likely to happen when an option is trading higher than the option’s strike price and is out-of-the-money. [1][4]
-
Close the Position When the Strike Price is Approached: One approach to managing short options is to close the position if the stock price nears your strike price. For instance, if you sold a put option with a $90 strike price when the stock was trading at $110 per share, you can avoid assignment by closing the position before the stock price falls below $90.
-
Roll Over the Option: Another method is to roll over your option. This involves closing your current position and simultaneously opening a new one with a different strike price and/or expiration date. Traders can roll their contracts to the same strike price with a later expiration date or adjust the strike price to maintain an out-of-the-money (OTM) status, either rolling it up or down as needed.
ASSIGNMENT EXAMPLES
How an Assignment can Occur:
-
If an investor sold a put option with a strike price of $95 and the stock's price fell to $85, the investor would still be obligated to purchase the stock at $95 per share
-
When an option is in-the-money (ITM), it typically means that the option seller is facing a disadvantageous situation.
-
From the buyer's perspective, when an option is in-the-money (ITM), it typically means that the buyer is in a favorable position.
-
-
If an investor sold a call option with a strike price of $100 and the stock's price rose to $110, the investor would be obligated to sell the stock at $100 per share.
-
When an option is in-the-money (ITM), it typically indicates that the option seller is in an unfavorable spot.
-
Conversely, for the buyer, an in-the-money (ITM) option usually signifies a favorable position.
-
How a Covered Call Assignment can Occur:
-
If an investor owns a covered call position with the underlying stock being at $90 per share while also selling a call option with the strike of $150, the investor will have to sell the $150 strike option if the strike is above $150 on the date of expiration but may keep the underlying shares.
-
Since the short call option is in-the-money (ITM), the investor is still obligated to sell the stock at $150 per share.
-
Thank you for taking the time to explore the intricacies of option assignment with us. We understand that the topic can be complex and sometimes daunting, especially for those new to options trading. However, gaining a clear understanding of how assignments work, why they occur, and how to navigate them is crucial for anyone looking to succeed in options trading. By understanding the dynamics between option buyers and sellers, the obligations involved, and the strategies to manage and prevent assignments, you are better equipped to make informed decisions and manage your positions effectively. We trust that this guide has provided valuable insights and clarity on this important aspect of options trading.
At ProbabilityofProfit.com, we are dedicated to delivering accurate and trustworthy content to our readers. Our team meticulously researches each topic, ensuring that the information we provide is both comprehensive and reliable. We reference high-quality sources, including academic journals, industry reports, and market analysis, to support our content. Additionally, we draw upon original studies and data from respected publishers to provide a well-rounded perspective.
Our commitment to accuracy means we constantly review and update our articles to reflect the latest developments and trends in options trading. We strive to present unbiased information, allowing our readers to make informed decisions based on solid evidence. Discover more about our rigorous standards and our dedication to excellence on our website.
- Schaeffer. “How Option Assignment Works: Understanding Options Assignment.” Nasdaq, www.nasdaq.com/articles/how-option-assignment-works:-understanding-options-assignment.
- “The Risks of Options Assignment.” Schwab Brokerage, www.schwab.com/learn/story/risks-options-assignment.
- Options Assignment. www.optionseducation.org/referencelibrary/faq/options-assignment.
- “Options Basics: How the Option Assignment Process Works.” Nasdaq, 23 July 2021, www.nasdaq.com/articles/options-basics:-how-the-option-assignment-process-works-2021-07-23.
Related Guides
OPTIONS MARKETS
CALL CREDIT SPREAD
A call credit spread, or bear call spread, entails selling a call option and simultaneously... Read More
OPTIONS MARKETS
PUT CREDIT SPREAD
A put credit spread, also known as a bull put spread, involves selling a put option... Read More
