Deep Dive into Options Assignment & Exercising

Back on Show 187, we tackled the top 15 questions we consistently receive around options expiration. Today, we’re taking a slightly different approach and addressing head-on the 18 biggest questions and concerns traders have around options assignment and exercising, whether on or before expiration itself. Regardless of your trading experience level, whether a seasoned investor or complete options newbie, I promise you today’s episode will help you more clearly understand and navigate any future options assignment or option exercise situation you might find yourself in. After all, this is part of the business, and if you trade long enough, you’ll have to manage through this multiple times.

People want to believe that options assignment and exercising will not happen to them. Thus, they do not take the time to learn what to do in situations like this. But, they will inevitably find themselves having to deal with options assignment and exercising and would do well to ‘eat the frog’ of learning how to handle these situations instead of being unprepared and making mistakes–in which case they will have to eat a far bigger frog!

1. Do I have to exercise my option contract to take profits?

• You can definitely convert the contract by exercising it, but you can also simply trade the contract itself back and forth. Simply trade the contract with somebody else before expiration to realize your profit.

2. How can I tell if I’ll be assigned stock when trading options?

• We do not know for sure if an assignment will come before expiration. The option buyer has the choice to assign that contract to you or not.
• It is helpful to think about what they’re giving up if they were to assign that contract early, though. Would they be willing to give up all of the extrinsic time value remaining in the contract to go through the exercise and assignment process? For example, suppose it’s 10 days before expiration, and there’s still $15 of extrinsic time, volatility, and interest value in that contract. In that case, they’re better served not exercising and just simply closing the option contract trade. In this case, it is detrimental to the buyer to exercise the contract early.
• It’s only until the last few days of expiration that all of that extrinsic time value starts to approach zero, which then increases the likelihood of the buyer assigning you the contract.

3. What to do when a short leg of a put spread is assigned?

• If you do not have the capital in your account to manage the position, it is better to reverse all the components one by one.
• If you have the capital to manage this position, all that’s happened is the components have changed slightly from being an option contract to an equity position. It’s going to behave and react similarly to what was already happening in the position. So, you do not need to panic.

4. Can I still be assigned stock after I close my options trade?

• No. Assignment only happens if you have an existing position or if you let a position go through the expiration process, and it’s in the money. It can’t happen after you’ve already closed an existing position.

5. Can you exercise your long option contract at any time?

• Yes (with an asterisk). The asterisk is if the option contract you’re trading is an equity option contract, not an index option contract. It would be better for you in many cases to simply reverse the trade and sell the contract itself to somebody else, not to exercise the contract and convert it into the underlying stock.

6. Are options automatically assigned when the strike price is breached?

• No. Just having the strike price go in-the-money by itself does not automatically mean that the option contract is assigned. The strike price being in-the-money only matters when you are at expiration itself. Once the contract is at expiration, and there’s no more time left, anything that is in-the-money that you let settle in the money can go through the assignment process.

7. Is it possible for an out-of-the-money option contract to get assigned?

• Yes, it’s definitely possible, but the buyer would be better off buying the underlying stock at the current price, versus converting an option contract that’s out-of-the-money.
• For example, let’s say that the stock we are trading is trading for $100 a share, and we have a $101 call option that we sold short. Why would the call option buyer choose to buy the stock at $101 from us when they could just as easily go out into the open market and buy the stock at the price that it’s trading at right now, which is a $100?
• That doesn’t mean that assignment can’t happen as expiration is getting close. There may be some news event, or somebody just hits a wrong button, and they exercise the contract by mistake.

8. How do I keep my covered call stock position from being assigned?

• You still have to think about it in terms of the option buyer on the other end. But now, we have to deal with a covered call position. If you have a stock position, you sell a covered call against that, the option buyer determines when the call option gets assigned to you, but they would hopefully only do that when after a lot of extrinsic value has been wasted away.

9. Can options be assigned before expiration?

• Yes. Most of the options contracts that are assigned or are exercised before expiration happen in the last week of expiration, more specifically in the last couple of days of the expiration cycle. That is because, at that point, options contracts start trading right towards their intrinsic value.

11. Can you exercise an option contract even if you do not have the buying power for the stock position?

• You have to check with your broker, but most of the big brokers are not going to allow you to exercise a contract if you do not have the buying power to hold the stock position that you are in because they know you do not have enough capital in your account to hold a large number of shares.

12. Why should you not exercise your option contract early?

• Somebody could exercise an option contract early, but why would they? You wouldn’t exercise your contract early if it means you forfeit some extrinsic value left in the contract. People worry when the option contract goes in the money. But, if it’s early, even 15 days before expiration, that doesn’t mean that they’re going to exercise, because there’s still some time value left in that contract.

13. What happens when an index option is exercised?

• When you trade an option contract on an index, there’s nothing to actually settle when you convert the contract over. That’s why they do not allow early exercise of these contracts because there’s nothing to settle to. What happens at expiration is it is cash-settled. No actual equity gets traded, and nothing happens with the underlying security because there’s nothing there to support the index option. It’s just basically an option contract based on the value of the index that it’s tracking.

14. Why can’t you exercise an option without the money to hold stock?

• No exchange – no broker – will allow you to exercise an option contract to buy 100 of stock if you do not have the money to buy the 100 shares of stock. If you had a dollar coupon to buy an Arby’s sandwich but didn’t have the rest of the money, would they let you buy the sandwich? Some brokers might allow the initial transaction to happen, but then they might immediately margin call you to deliver additional capital, or they might reverse the trade the same day.

15. Can index options like SPX be exercised?

• No. As above, index options like SPX and RUT are not able to be exercised ahead of expiration. They auto-exercise right at expiration, and they settle to the cash value of the contract at that time.

16. Is it better to exercise an option or sell it?

• It firstly depends on what your goals are for trading. If your goal is to take delivery of the shares, you might want to exercise.
• When it comes to the financial position that you are in, choosing between exercising an option contract or just simply selling it back brings you back to the decision of whether or not the option contract has extrinsic value remaining. Suppose there’s a lot of extrinsic value remaining, and it’s got a lot of volatility value. In that case, it is always way better to simply reverse the trade by selling the contract itself instead of converting the contract into underlying stock and then trying to reverse the position that way.

17. Do stocks expire like options?

• Technically, no. A stock can live forever if the company is still around and the stock is still publicly traded and liquid enough to be traded.
• Companies do get bought out, or they go bankrupt or merge, though. So, stocks do, in many cases, eventually, stop trading.
• This is why people like stocks because options are hard to manage and have expirations.

18. What happens when an option is assigned early?

• The first thing that happens is that the order gets routed through the OCC, who clears the trade and randomly assigns another member broker, who randomly assigns a customer. The process by which the assignment happens is totally random.
• Secondly, the conversion of the option contract to the underlying shares takes place. When the buyer exercises their contract and assigns it to the seller, the conversion happens where the buyer buys shares at the strike price, and the seller sells shares at the strike price. If the seller has the shares in their account, they get taken and transferred to the buyer. If the seller doesn’t have the shares, they go short stock at the strike price and sell the shares to the buyer at the same strike price.
• From there, it just becomes a matter of if the seller has enough capital to manage these positions moving forward. If the option buyer chooses to exercise their contract, they would have already had to have the capital to hold the position for most brokerages. Suppose the seller gets assigned a contract and doesn’t have the capital to hold on to it. In that case, the brokers allow them, that day, usually, to reverse the trade and cover the position if they need to – basically buy back the shares in the open market and remove the need to bring in additional capital.
• If not, then the seller has to transfer money to hold on to the position, or basically get their margin call that says, “Hey, you need some more money in this account if you want to hold on to this position.”
• Those are the main two processes that happen when options are assigned early ahead of expiration. It is exactly the same process that happens when you get to expiration too. It is just not forced from one party to another but instead done automatically because now we’re at expiration itself.

Option Trader Q&A w/ Patrick

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Patrick:

Hello, Kirk. My name is Brad. I’ve been trading options since March of 2018. Initially, I had not discovered Option Alpha. Sometime around in April, I discovered it. I’ve been listening to a couple of other guys. There was really no comparison after I went through some of your free video training. I later just joined as a basic member and it’s really been great for me. I started with iron condors and have really settled in on iron butterflies for the moment. I know no one strategy is good forever, but I like the potential return on iron butterflies. I feel like I’m in a good rhythm with using IV rank, position size, diversifying across different ETFs, using profit targets. Laddering has been particularly important with really understanding how to move with the market, rolling for credits, going inverted when it’s absolutely necessary. I really feel I’m in a good rhythm.

I do have one question though. Well, not just one, but today’s question is when I am laddering into a position, let’s say it’s EWW, I’m laddering in, the market is moving up, I’m taking my unchallenged position, let’s say my put side, short strikes, I’m moving them up with the market as I’m laddering in. My question is, I understand the relationship between the short strikes and need to move with the market, but is there anything that we need to watch out for related to where we set the short strikes as compared to the long strikes on the other positions on that same security, that same EWW as I’m laddering in? Are there any no-no’s relative to where I put that new short strike that I’m moving with the market and the long strike on the other positions, the other iron butterflies that I have?

That’s my question. Thanks for everything. Keep it up. It’s great. Thank you very much.”

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.