Option Exercise and Early Assignment: Part 1

optionsguy posted on 12/13/13 at 10:22 AM

If you're selling options -- either as single contracts or as part of spreads or another strategy -- chances are, sooner or later, you'll get hit with a surprise early assignment. Fact is, too many traders have never planned for this possibility and feel like their strategy is falling apart when it does happen. How can you stay prepared and react to early assignment intelligently? Let's break down some scenarios.

First, to the dictionary!

Always good to define our terms before really diving in. Options are really contracts conferring rights and obligations. The buyer of an option is paying for a certain right: to buy or sell a stock at the strike price. Option buyers, those who are long the contract, hold the rights and therefore call all the shots. If a buyer decides to exercise those rights before expiration -- well, fittingly, that's called early exercise.

Now put yourself in the option seller's shoes, i.e., those who've shorted the option. Option sellers take on certain obligations and get compensated for taking on those obligations by the proceeds of the option sale. If you sell a call, you must be ready to sell stock at the strike price; if you sell a put, you stand ready to buy stock at the strike price. Again, as an options seller, you aren't running the show, because the options buyers have all the rights. Instead you may be subject to assignment: fulfilling on your contractual obligation if a buyer decides to exercise the contract. Below is a table that outlines the rights and obligations of the four basic option positions. 



What happens at assignment, anyway?

"Assignment" happens via a random lottery system run by the Options Clearing Corporation (OCC). When the OCC receives an exercise notice from the owner of an option contract, it's assigned randomly to a member firm -- possibly your brokerage firm. Your broker in turn assigns exercise notices to short options positions, either randomly or on a "first-in, first-out" basis.

So how often are options exercised / assigned?

Many first time options traders wrongly assume just because an option contract becomes in-the-money (i.e. has intrinsic value) the buyer will exercise his or her right instantly. This simply is not the case and we will discuss this concept in more detail in a later post. Now, let’s think about the various outcomes that can happen after the position is established and how often each tends to happen. 

Okay, let’s just say you've bought or sold options to open a long or short position. What now? There are three possible results of the trade. 

1) The options are bought or sold to "close" the position prior to expiration.

2) The options expire worthless.

3) The options are exercised or assigned prior to or at expiration, resulting in a trade of the underlying stock.

A common misconception is that #2 is the most frequent result, but actually #1 is (That's why I listed it as #1 here).

If the option trade is working in your favor, you can choose to cash in. If, on the other hand, the trade is going against you, it's perfectly fine to cut your losses and close out the trade early. After all, you don't have to wait until expiration to "see what happens." Once an option is closed in the marketplace, it ceases to exist. That's why when you enter an order, it says buy or sell "to open" or "to close." The Options Clearing Corporation keeps track of those stats and displays them to the public as the figure called Open Interest. If more of the trading volume is marked closing, then the next day the open interest number decreases. If more volume is marked opening, the open interest will increase. In other words, options aren’t necessarily hot potatoes that get passed around and eventually wind up in someone’s hands at expiration. Below is pie chart that shows how often on a percentage base each of these scenarios tend to occur.

 

For many options traders, the fact that 7.2% of options are exercised/assigned is surprising. This doesn't imply exactly 7.2% of your short positions will be assigned, but it is a big-enough figure to suggest that you if continuously have a short option position in your account, eventually you'll likely be assigned, and sooner or later that may happen prior to expiration. If you are short a stock option, the only way to assure that you will not be assigned is to buy to close the position, thus removing your obligation.  

The plot thickens…

In my next post we'll talk about why and introduce some factors that may increase the chances for early assignment. Those factors differ slightly depending on whether you're selling calls or puts, so we'll divide the discussion accordingly.

After that, we'll get into some math that will help determine if an option contract is a likely candidate for a possible early exercise/assignment. Essentially, an option buyer uses certain synthetic relationships and the “cost-to-carry” to decide when conditions are right to exercise. I'll show you a few calculations to make that decision clearer from the buyer's perspective -- which can help make you that much more ready to act if you're assigned as a seller.

Regards, 
Brian (OG)

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Posted by optionsguy on 12/13/13 at 10:22 AM

Comments

spshapiro posted December 14, 2013 (09:08PM)

Brian, I have no problem with the way you describe the logistics of early exercise, in fact I have no doubt that many new to the use of options treat such an event as a surprise. But it is no more of a surprise than some players of Russian roulette walk away with messy pants. There really is no surprise here, for I know of no one who sells options with any regularity that hasn’t been assigned at some point. I would go as far to say that there are less instances of never assigned option sellers than there are veteran Russian roulette players.

I hope I’m not jumping the gun on Part II, but I believe that you must have the eventuality of assignment in mind when you decide to be a seller. I am not saying that I’m not aware that there are some tactics that can obviate exercise, most often by choosing strikes well OTM, but sometimes the best laid plans….Nothing can screw up your well devised plan than an overnight buyout offer or a surprise raid by the Justice department. No matter what your due diligence, sometimes things move faster than could be expected, yesterday.

Because of this reality, I will never sell a put on a stock that I don’t really wish to own, but at maybe a cheaper price than the current one. I will never sell a covered call unless I am prepared to take the capital gain at the strike price, and if desired, buy the stock back later.

Thanks for the graph on options outcomes. It is not a big surprise that over 70% of all options are ‘settled’ before expiration. I take it that fact is supported by the knowledge of many that allowing a position to continue to deteriorate is just foolish, and it is better to get something rather than nothing. However, I am surprised that of those options that go all the way to expiration, that worthless only beats exercised 3 to 1. I would have thought that there are still enough new options users, or hopeless romantics that worthless would have won by even a bigger number.

optionsguy posted December 16, 2013 (10:58AM)

Hello spshapiro,


In your comment you said “However, I am surprised that of those options that go all the way to expiration, that worthless only beats exercised 3 to 1.” Yes, the “expire worthless” is probably the one number that I hear quoted incorrectly the most. I have even heard so called professional’s say as much as “80% of options expire worthless.” Which is simply not the case, at least not according to the options clearing corporation.


Part two will be posted this week.


Regards,

Brian (Og)

spshapiro posted December 17, 2013 (07:18AM)

Having known several MM’s as personal friends (I hope the FBI doesn’t eavesdrop on this), I’m aware that they mainly want to mainly make their money on the vig (the difference between the bid and ask.)  In other words they want to minimize their risk by holding as little inventory exposing themselves to either side of a trade. So the fact that many options would be ‘disposed of’ before expiration date is not a surprise, since the last thing a good MM wants to do is be in a position where they could get hurt by a sudden change in the underlying.

Our friend OF was fond of remonstrating me that only an idiot would hold on to an open option’s position when you have captured a large portion of the premium received, in the vain hope that you will pick up the rest of it holding through expiration. Experience has shown me that I’m far better off taking 40% overnight, or 60% within a week, than waiting a month or more to capture the whole “enchilada”.

Instead of saying 80% of options expire worthless, perhaps it should be said more than 90% never are exercised.

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