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What happens when a sold option is assigned? How about when a bought option is exercised? This article will answer both these questions along with a few other facets that readers may be unaware of, especially those a little wet behind the ears when it comes to option trading.

Before diving into the deep end, let’s quickly recap the basic premise of exercising an option. The buyer of an American style call option has the right to take delivery of the underlying shares at any time before the expiration day. Conversely the seller of an American style call option is obliged to deliver the shares in the underlying should the buyer exercise their right.

The same right and obligation applies for the buyer and seller of a put option. However the put buyer has the right to be short shares (or put shares) whilst the trader on the other end, the put seller, has the obligation of supplying the short shares to the buyer. Still a little confused? Below are two examples that will hopefully demist any fog that remains regarding assignment.

Trade 1 Autodesk Call Calendar Spread
November 21^st 2007 ADSK close price $45.23
Buy 1 ADSK Jan08 45 call
Sell 1 ADSK Dec07 45 call

Moving forward to three days before expiration, December 19^th, ADSK closed at $49.78 and on this day the short option was exercised when it was trading $4.78 (49.78 – 45) in-the-money [ITM]. When an option buyer exercises their right the exchange randomly assigns the trade to a seller. Later in this article I will cover how to monitor for likely assignment.

Since in this trade a call has been sold we are obliged to deliver 100 shares to the option buyer at $45. To counteract this transaction the call seller’s (our) account will be short 100 shares (100 long shares + 100 short shares = zero total). The account now shows the following:

• Long 1 ADSK Jan08 45 call (bid/ask 5.10/5.40)
• Short 100 ADSK shares sold at $45. Current market price $49.78 (unrealised loss $478)

Has our risk profile changed? No! The long Jan08 45 call gives our 100 short shares limited risk and the risk graph would show a synthetic long put (limited risk, unlimited profit to zero). The maximum risk is still confined to the initial entry debit of the original calendar spread.

To close the new synthetic put position simply buy back the 100 shares and sell the Jan08 45 call. This can be done on one ticket or by buying the shares and then selling the long call. Never sell the call before buying the shares because this would leave you with short shares and potentially unlimited risk.

Could the long leg be exercised to close out the trade? Yes it could, but the long call still has $0.32 (*100 = $32) of time value remaining. By exercising the long leg we are taking the maximum risk on the trade (entry debit) and giving this time value away. We would be at least $32 worse off. I say at least because through shaving a little more time value may be captured.

Trade 2 UBS Bull Put Credit Spread
December 5^th 2007 UBS close price $49.36
Buy 1 Dec07 45 put
Sell 1 Dec07 50 put

Nine days later (December 14^th) UBS has moved down and is now trading at $47.35. The short leg (bid/ask 2.5/3.1) has been assigned to our account. When a short put is assigned we are obliged to deliver 100 short shares to the exerciser. Therefore the option buyer is now short 100 shares and our account is long 100 shares (100 short shares + 100 long shares = zero). Our account would show the following-

• Long 1 UBS Dec07 45 put (bid/ask 0.30/0.40)
• Long 100 UBS shares bought at $50. Current market price $47.35 (unrealised loss $265)

How has this affected our risk profile? Once again it hasn’t! Essentially the trade is now a synthetic long call because we are long 100 shares and have a protective put with a strike of $45. The maximum risk is the same as it was when the position was opened (difference in strike prices less the credit received).

The best way to exit this position is to sell 100 long shares and sell the Dec07 45 put. Once again never sell the put before closing out the long share position otherwise you will be exposed to unlimited risk down to a share price of zero. The only time to exercise the long 45 put is when it is ITM and there is no time value left. If the long put value was less than the commission charged by the broker then it would make sense to only sell the shares and keep the worthless put as a lottery play.

How can you tell if your short position is likely to be assigned? It comes down to time value. If the option is ITM and has less than $0.05 of time value then there is a good chance you will be assigned. Calculating the time value for:

• Calls = Share Price – Strike Price = Intrinsic [ITM] Amount
• Option Bid Price - ITM amount = Extrinsic or Time Value
• Puts = Strike Price – Share Price = Intrinsic [ITM] Amount
• Option Bid Price - ITM amount = Extrinsic or Time Value

You may have noticed in the two examples provided I did not mention the initial trade debit/credit. This figure is irrelevant as to whether you are likely to be assigned. It all comes down to whether there is any time value. If there is no time value and there is still time remaining to expiration then you are not guaranteed of being assigned. The important point is whilst there is time value it is unlikely you will be assigned because the option buyer would be foregoing dollars in doing so however once there is no time value remaining in the position then there is a chance you will be assigned. The information in this paragraph is commonly misunderstood by newer students.

At expiration all options that are $0.01 or greater ITM are automatically exercised by your broker. It is also important that traders be aware that some brokers give their clients 24 hours to take action on assigned short positions whilst others close out other open positions in the account should there be insufficient funds to cover the newly acquainted long share position or if there is insufficient funds to meet margin requirements on the new short share position.

Understanding assignment is very important. If you know what will happen if you are assigned then there won’t be any unexpected long/short shares turning up in your account. Having this knowledge will allow you to take the appropriate action in closing out the position in the most cost effective manner. If you are still confused by the option assignment process I suggest you come back to this article in the near future and work through the examples provided in Platinum or with a pen and pencil. Pacific rim students may wish to read a previous article on this topic I wrote by clicking on the following link Assignment - Is it really that scary?. Those who are enrolled to attend an upcoming 3-Day ICT Seminar will also benefit from discussions regarding assignment.

Happy New Year to you all!


Guy Halpin
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site

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