Exercise & Assignment
Exercise and assignment of options refers to the process of settlement in accordance with the terms of the contract. Exercise and assignment of options contracts are two sides of the same transaction. An option buyer has the right to exercise an options contract. An options seller is obligated to accept assignment from an exercised options contract.
An options holder has the right to exercise his or her stock option at the option’s strike price. Options buyers are the only party that can exercise an options contract. For example, someone who is long a call option may choose to exercise the call option.
The decision to exercise depends on the options contract’s specifications, whether it is an American or European-style option, the underlying’s current price, the options contract’s strike price, the length of time remaining on the options contract, and the option holder’s outlook on the underlying security. For options contracts where there is no physical delivery of the underlying (shares of stock, barrels of crude oil, etc.), the exercise settlement value is determined at expiration and a cash settlement amount is calculated.
When an options contract is exercised, the owner of the option invokes the right to buy or sell. Options exercise is the process of converting an options contract into the underlying shares of stock. Exercising an options contract is irrevocable as exercise begins the process of assignment by the OCC. Options contract buyers may exercise the contract anytime before expiration with American-style contracts. Exercising prior to expiration may occur for a number of reasons, such as the desire to receive a dividend payment on the underlying stock or to fulfill an obligation for another position in the portfolio.
The assignment process is facilitated by the OCC. For example, a call option holder sends an exercise notice to their broker. The broker then sends a notice of exercise to the OCC. The OCC randomly selects a clearing member firm who is short the exercised contract and assigns the firm the exercise. The clearing member firm assigns the exercise to one of its customers (either randomly or on a first-in, first-out basis) who holds the short position. The assigned call writer must deliver the shares to fulfill the obligation of the assignment. The broker then delivers the call writer’s shares to the OCC who delivers the shares to the broker whose customer initially exercised the call option.
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 7% of options contracts.
Early assignment is the assignment of an options contract before the expiration date. Early assignment of options contracts is only possible with American-style contracts. Once an options contract has been sold, the writer of the option is at risk of early assignment and accepts the responsibility of obligation to fulfill the terms of the contract.
Early assignment may happen for a number of reasons. For example, early assignment may happen because the contract holder wishes to receive a dividend payment from the underlying security. Early assignment may happen because a trader with another position was assigned a contract and is short shares of stock.
The OCC uses a random assignment process to ensure fairness in the distribution of options assignments. The OCC randomly selects a clearing member account maintained with the OCC for the assignment. The assigned brokerage firm must then use one of two methods to notify its accounts of the assignment. The two approved methods for assignment are random or first-in, first-out.
Risk of Assignment
Equity options sellers are at risk of assignment at any time. However, it is usually in the option buyer’s best interest not to exercise an options contract early, but there are circumstances that increase the risk of assignment. The majority of options exercises, and therefore options assignments, occur near expiration.
In-the-money options contracts with time remaining until expiration have both intrinsic value and extrinsic value, so assignment does not typically occur until the majority of the time value has decayed and expiration is near. In-the-money put options are more likely to be assigned early than in-the-money call options because exercisers of put options sell stock and receive cash. Exercisers of call options purchase stock and must pay cash; therefore, the time value of money impacts the decision to expend cash early prior to expiration.
Risk of early assignment of a short call option position is greatest when the underlying security pays a dividend, the call option is in-the-money, and the time value of the option is less than the dividend amount. For a call option holder or buyer to receive the dividend payment from an exercised option, the exercise must happen on or before the ex-dividend date of the underlying security. A notice of assignment in this case typically happens on the ex-dividend date. A short call option that is in-the-money is most at risk of dividend assignment. In-the-money short call options are at risk of early assignment during dividend payment dates when the value of the corresponding put option with the same strike price as the call option is worth less than the dividend payment amount.
Closing Assigned Positions
When a call option seller is assigned a position the seller is obligated to sell shares of the underlying stock or deliver the underlying commodity at the contract’s strike price. To fulfill the obligation of the exercised contract, the seller must deliver 100 shares per contract, in the case of equity options, of the underlying security at the contract’s strike price.
If the seller owns shares of the contract’s underlying security (as is the case with a covered call, for example), the long stock position in the seller’s account will be used to honor the assignment. If the seller does not hold shares of the underlying security, the seller’s account will show a short position in the underlying security. To cover the short shares, the seller must purchase shares of stock at the current market price to reverse the trade and close the position.
When a put option seller is assigned a position, the seller is obligated to purchase shares of the underlying stock at the contract’s strike price. Typically, the seller’s account had the margin required to purchase the stock held in reserve to offset the potential assignment of the put option.
For example, if the seller opens a short put contract of a stock at a strike price of $50, they would need to have $5,000 available in their account at the time they opened the option position to cover the cost of buying 100 shares of stock. Once assigned, the seller is now long the underlying security and can either continue to hold stock or sell the shares at the current market price to close the assigned position.
Dividend assignment risk is the risk of being assigned the obligation to pay a dividend on a short call position. Call options sellers may be assigned the responsibility of paying a dividend. Because call options sellers are short the underlying security when the security goes ex-dividend, the seller may owe the dividend on the security. The amount of the assigned dividend payment is then deducted from the seller’s account. Because of the additional cash outlay from the dividend payment, dividend assignment risk increases the maximum loss potential on a short call option position. Dividend assignment risk is greatest on or just before the ex-dividend date.
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What is dividend risk in options?
Dividend assignment risk is the risk of being assigned the obligation to pay a dividend on a short call position. Call options sellers may be assigned the responsibility of paying a dividend if they are short the underlying security when the security goes ex-dividend. Dividend assignment risk is greatest when a short call option is in-the-money on, or just before, the ex-dividend date.
How do dividends work on options?
Dividends affect the premium of an option by reflecting the drop in price of the underlying asset as a result of the dividend payment. When a security pays a dividend, the stock’s price declines by the dividend amount as the dividend is no longer a future expected cash flow. Dividend payment dates are known in advance and priced into options, which will result in more expensive put options and less expensive call options. If the holder of a call option wants to receive the dividend, they will need to exercise the option prior to the ex-dividend date. If an option seller is assigned a short call option before the ex-dividend date, they will be required to pay the dividend, as they will be short the stock.
Do option sellers pay dividends?
If an option seller is assigned a short call option before the ex-dividend date, they will be required to pay the dividend, as they will be short the stock. If the seller is not assigned the underlying security, they will not be responsible for paying the dividend.
What does it mean to exercise an option?
The holder of a long stock option has the right, but no obligation, to exercise an option at any time before expiration. If the option is exercised, shares will be delivered at the strike price per the contract terms. For example, if a long call stock option with a $50 strike price is exercised, 100 shares per contract will be purchased at $50 a share. If the underlying stock is trading at $55, the account will immediately experience an unrealized gain of $500, minus the original debit paid to purchase the long call option.
What happens when you exercise an option?
When an option is exercised, shares of the underlying security will be delivered at the strike price per the terms of the contract terms. If a long call option is exercised, the investor will be long shares of stock. If a long put option is exercised, the investor will be short shares of stock.
How do I exercise stock options?
Options exercise is the process by which the buyer of an option submits a request to his or her broker to exercise the rights of an options contract. The broker will execute the transaction by assigning the contract to a seller of the same option. The exact process varies from broker to broker, but it may be as simple as calling the brokerage firm or clicking on a position and selecting exercise.
How do I avoid option assignment?
If an option is at risk of assignment, and the writer of the option does not wish to receive shares per the terms of the contract, they can avoid assignment by exiting the position. This is accomplished by buying-to-close (BTC) the option position.