Option assignment is when an option seller is required to fulfill the obligation of the option per the contract’s terms. If an option buyer exercises their right to buy or sell shares of stock at the strike price, the option seller must honor this request and fulfill their obligation.
Option buyers have the right to exercise an option at any time. Option sellers are obligated to accept assignment if the buyer exercises the option. Option assignment is random and cannot be refused.
Options can be assigned until 30 minutes after the market closes (4:30 pm EST). An option must be closed before the end of the market day to avoid potential assignment. If a short option is not closed before the market closes at 4:00 pm EST, the option is subject to assignment.
If assigned a call option, you must sell 100 shares per contract at the option’s strike price. Conversely, if you are assigned a put option, you’re required to buy 100 shares per contract at the option’s strike price.
As an option seller, assignment risk is something you must understand, but it is not as scary as many think. We will outline assignment, how to manage the associated risks, and what to do if you’re assigned.
How does option assignment work?
Option assignment occurs when the owner of an option exercises their right to buy or sell the underlying asset at a specific price on or before expiration. When a call option is assigned, the owner buys shares at the strike price.
For example, if XYZ stock is trading for $45 and you sold one XYZ 50 Put, the put buyer has the right to sell 100 shares of XYZ at $50 any time until expiration. If XYZ drops below $50 before expiration and the buyer exercises the option, then you will be assigned 100 shares at $50 and are obligated to purchase the shares.
The OCC facilitates the assignment process.
Assume the put option holder sends a request to exercise their put option. The broker then sends a notice of exercise to the Options Clearing Corporation (OCC). The OCC randomly selects a clearing member firm that is short the exercised contract and assigns the firm the exercised option. The clearing member firm assigns the exercise to one of its customers holding the short option (either randomly or on a first-in, first-out basis). The assigned put writer must purchase the shares to fulfill the obligation of the assignment. The broker then delivers the put writer’s shares to the OCC, who delivers the shares to the broker whose customer initially exercised the call option.
How to avoid early option assignment
Options are typically assigned near expiration when the strike price is in-the-money (ITM). Option buyers tend to hold the contract as long as possible to capture as much extrinsic value as possible. At expiration, there is no incentive for the buyer not to exercise the option since they will make money by doing so.
For example, an option $5 ITM has $5 an intrinsic value of $5. The more time until expiration, the more extrinsic value an option has. At expiration, an option has $0 extrinsic value, so it is in the buyer’s best interest to exercise the option. For example, the owner of a $50 call option will make $500 per contract if they exercise the option when the underlying security is trading at $55.
Another reason options may be exercised early is if the underlying stock pays dividends before expiration. Since call options give the buyer the right to buy shares at the strike price, any dividends paid on those shares would also go to the option holder if they exercise the option before the ex-dividend date. Therefore, sellers may want to close out their positions before expiration if an ITM call or put has significant intrinsic value and it looks like it might be assigned early due to dividend payments.
Managing assignment risk
Understanding how assignment works can help with position management before expiration. Most assignments only occur very late in the expiration cycle for ITM options with little extrinsic value.
To manage assignment risk and *potentially avoid assignment, you should consider closing short options with intrinsic value (i.e., in-the-money) near expiration.
You can use Option Alpha automations to manage assignment risk. It is important to note that there is no way to guarantee you’ll avoid assignment. But you can use a series of decision recipes to check for key contributing factors such as days until expiration and moneyness automatically inside a bot.
Best Practices: What to know about assignment
Despite your best efforts, you may still be assigned shares of stock. While many make it out to be a terrifying experience, there are a few things you should know if you are assigned.
- Don’t panic! Assignment comes with the territory when selling options. Typically, your broker will give you a day to exit the assigned position. Check with your broker for specific details about their assignment process.
- Use vertical spreads. Credit spreads have defined risk, so you know your max potential loss. A credit spread’s max loss is the premium received minus the spread width. For example, if you sell a $5 wide spread and collect $2, your max loss is -$300 per contract. So, even if the short option is $8 ITM and assigned, you can exercise the long option for $3. Added to the initial $2 premium, your loss is -$300.
- If you have enough capital to cover the cost of assignment (and the appropriate margin account type for holding short stock if a call option is assigned), you can consider holding the position if you believe it will become profitable.
Remember, option assignment is rare. The majority of options contracts are closed prior to expiration or expire worthless, and assignment does not typically occur. According to the OCC, options holders only exercise about 8% of options contracts.