The Difference Between Option Exercise and Assignment

Option exercise and assignment are two very basic principals of option trading but can be very confusing to a new option trader. We easily understand some parts of options because we can find similarities from our history of stock trading. Unfortunately exercise and assignment is not one of those similarities.

Unlike with straight stock trading there are many different ways to close out an option. Some of these ways are dependent on if you are long or short or what your trading goals are. Most you have control over but there are some ways where you give up your control.

As we discuss what exactly exercise and assignment are we will also talk about the many different ways you can close out an option and when exactly you should do it. We will dig into more advanced topics such as the effect of dividends and how they can change when you should close out an option.

What Is Option Exercise?

Before we break out the textbook definition of exercising an option let's backup and talk about who should deal with exercising and who gets assignment.

Like stock you can go long or short options: long call, short call, long put and short put. If you go long a call or long a put you are the buyer, you hold the power in this option contract. To enter into this trade you are 'Buying to Open' your call or put. This also means you do not have to worry about option assignment, you get to deal with option exercise.

If you go short a call or short a put you are the seller, writer, and you are obligated to fulfill the requirements of your option contract. To enter into this trade your are 'Selling to Open' your call or put. If you are short a call or a put you have to think about option assignment.

When you are the buyer of an option you have a couple of ways you can close that option out. You can either simply close the option in the market, let it expire worthless or exercise the option.

According to Brain Overby of all the options in the market approximately 17% are exercised, 35% expire worthless and 48% are closed out in the market.

Closing out an option in the marketplace is the most used method. This is because it is the most like trading regular stock and has the ability to be used whenever you need.

You can close out an option in the market if:

  • You are either long or short your option

  • It is currently trading at a profit or a loss

  • It is before or at its expiration date

  • Basically whenever and wherever you feel like it

Let's look at some examples to make more sense of this.

The Option Prophet (sym: TOP) has a call option trading for $5.00 and expires in two-months. We decide that TOP is going to go up in price so we want to get long this call, we 'Buy to Open' our call for $5.00. We ended up being right about our decision and TOP has begun to move higher. Even though it is only two-weeks after we have bought our call it is now trading for $8.00. We decide that move is good enough for us so we want to close our position and take the profit. We go back to our order screen and 'Sell to Close' our call for $8.00. We made a $3.00 profit on the play.

Later down the road we see TOP has remained elevated and we think it is going to move lower. Instead of longing a put we decide to short a call (bearish position) for $3.00. To enter this position we 'Sold to Open' our call. Unfortunately this time we were wrong and the momentum in TOP has pushed it higher. Now our call is worth $5.00 and we decide we have had enough and want to close the position in the market. We go back to our order screen and enter a 'Buy to Close' order for $5.00. We lost $2.00 on this trade.

Letting an option expire worthless is the easiest method to use but it either means you are taking the full loss or the full gain depending on the position.

You can let an option expire worthless if:

  • You are either long or short your option

  • The option is at expiration

The first thing you should notice about letting an option expire worthless is that it has to be at expiration. This is a situation where you don't actually have to do anything or enter any orders. The option will expire and disappear from your account and never be heard from again. The nice part about an option expiring worthless is that you do not have to pay a commission to close the position.

Again, examples will help us illustrate.

You believe TOP is going to make a huge move lower so you are going to go long some deep out-of-the-money puts for $0.50 that expire next week. Unfortunately this time you got the direction wrong and TOP moved higher dropping the value of your puts. Since the puts are not worth anything anymore you are just going to let them run their course. At expiration your puts will be worth $0. The contracts will be removed from your account and you will have a total loss on that position.

You now realize you can't bet on TOP going lower so you want to get short puts (bullish play). You see some out-of-the-money puts worth $1.50 and you 'Sell to Open' those contracts. This time your decision was right as TOP launches higher and never looks back. Your puts quickly drop in value (a good thing). You decide your position is safe and you are going to hold your short puts till expiration. At expiration your puts will be worth $0. The contracts will be removed from your account and you will have a total gain on that position.

All out-of-the-money options go to $0 at expiration. These are the only options that can expire worthless. In-the-money options CANNOT expire worthless. If you are long options that expire worthless you will have a loss. If you are short options that expire worthless you will have a gain.

Now that we've made it through the different ways to close an option we can begin to discuss exercise.

The buyer of a call option has the right to buy shares at the strike price. This is the basic definition of a call option and specifically deals with the right to exercise your option. Simply put exercising your call option trades your option in for the underlying.

The buyer of a put option has the right to sell shares at the strike price. This is the basic definition of a put option and, again, specifically deals with the right to exercise your option. Simply put exercising your put option trades your option in for short shares.

You can exercise an option if:

  • You are long a call or put option

It is true that there is only one requirement but we will have rules of when you should and shouldn't exercise your option.

Another TOP example!

You are currently long two call options on TOP at the $50 strike. TOP is currently trading at $55.00 (your option is in-the-money) and you think this is going to be a good long term hold so you want to exercise your option and pick up the shares. When you exercise you will get rid of your option contracts and convert them into 200 shares (because we had two contracts) of TOP at $50/per share. This gives you a total price of $10,000.00. As you can see TOP is currently trading at $55.00 so you start with a profit of $1,000 (200 x 55 - 10,000). What you don't want to do is simply turn around and sell your shares to collect that profit. If that was your goal you could simply close out your option by selling it back in the marketplace instead of exercising.

You are currently short one put option on TOP at the $35 strike. TOP is currently trading at $20.00 (your option is in-the-money) and you think this dog is dropping to the floor (going lower). You want to exercise your put option and get short TOP at $35. When you exercise your option you will get rid of your option contract and convert it into short 100 shares of TOP at $35.

Remember, most people don't exercise their options, only 17%. Most option traders have no desire or the funds to convert their options into shares or short shares.

Now let's discuss some rules. These rules will help us from screwing up when it comes to exercising but like all good rules there will be exceptions which we will discuss.

Rule #1:
Never exercise an option that is out-of-the-money. Exercising options is meant for in-the-money options only. This is easily explained with an example.

You are long a call at the 50 strike. Your underlying is currently trading at $40 and you decide to exercise. Now you have converted your option into shares at $50.00 even though the underlying is only trading at $40, you have a loss. If you wanted to get the shares of the stock you should have closed out your option ('Sell to Close') and bought the shares in the market for $40 instead of $50. Don't set yourself up by starting with a loss, only exercise in-the-money options.

Rule #2:
Never exercise an option before expiration. By exercising before expiration you are forfeiting the properties of the option that you have already paid for.

There are two main reasons for this rule. First you will forfeit the time value of the option. If your underlying is trading at $50 and your long a call option at the $45 strike you will have at least a $5 profit (50 - 45). If you exercise your option before expiration that is your only profit on that position. If you have time remaining before expiration your call will have a higher profit by itself. The profit on your call would be $5 + time value. As soon as you exercise you lose the time value. You could 'Sell to Close' the option in the market for more than $5 if it is before expiration. The closer you get to expiration the more your time value decreases until it reaches $0. At expiration your call would be worth $5 and that is when you exercise.

The second reason you don't exercise before expiration is because you forfeit the insurance options provide. You are long a call on the $30 strike that cost $3.00 and expires in two-weeks and your underlying is trading for $40. You decide your close enough to expiration and want to exercise your call. You no longer have your option and now hold 100 shares at $30. The next day a surprise announcement is released that the company is under investigation for fraud. The stock begins to sink and at the end of the day is worth $20. You are now sitting on a $1,000 loss. If you would have held your option it would probably be worthless now but your total loss would have only been $300.

How Do You Exercise Your Option

Some but not all brokerages have a button on their trading platform that allows for easy exercising. A lot of brokerages still make you call in and tell them you want to exercise your option. If an option is slightly ($0.01) in-the-money it will automatically be exercised at expiration. If you have no intention or desire to exercise your options make sure your close out your in-the-money options at expiration.

What Is Option Assignment?

Option assignment is simply the flip-side of exercising an option. When talking about exercising an option we noted that only a buyer (long call or long put) can exercise the option. When they do decide to exercise their option a seller (short call or short put) gets assigned.

When you are short an option, call or put, you do not have the right or choice to assign the option. You have the obligation to fulfill the assignment when a buyer exercises.

So what does that mean exactly.

If you are short a call and the buyer decides to exercise (trade their option for shares) you must sell them those shares. Now if you are holding those shares in your account, as in a covered call, you would simply lose some of your shares and they would get them. If you are not holding those shares in your account, as in a naked call, you would then be short those shares and they would get them.

If you are short a put and the buyer decides to exercise (trade their option for short shares) you must buy those shares. You would now be long shares in your account instead of holding the option.

The process of matching up a buyer and a seller for exercise and assignment is done at random. The buyer's brokerage tells the Option Clearing Corporation ("OCC") that there is an exercise notice. The OCC will find another brokerage that matches the requirements to fulfill the exercise (same option contracts). That brokerage will then place the assignment notice to an account holder that is short those options.

You should almost never worry about being assigned when an option is out-of-the-money. It has happened in the past but it is rare. Even though your option may not be at expiration if it is in-the-money you should be ready for assignment. Assignment is not likely but can happen before expiration. Not everyone follows our rules. Never let an in-the-money option reach expiration, it will be assigned.

How Dividends Affect Early Assignment

Remember when we talked about exceptions to our rules? Well the exception comes in the form of a dividend.

Options don't collect or pay out dividends. You have to hold the stock to collect dividends or short the stock to pay dividends, and you have to do this on the ex-dividend date. The ex-dividend date is the date that the company records all the share holders so it can pay dividends to them. If you buy the stock after that you will not receive a dividend.

If there is little time value left in our option and it is in-the-money you can exercise the option to collect the profit and the dividend from the company.

If you are short options be aware of when a company has its ex-dividend date. You could be looking at an early assignment if yo are not prepared. The easiest thing to do is simply close out your in-the-money option before it gets to that date.

Conclusion

A lot of option traders get caught up in what happens to options at expiration and if they need to exercise to profit from their option. Luckily there are better solutions that don't require you to wait such as simply closing the position out with a 'Sell to Close' or 'Buy to Close' order.

When you are long an option you have all the power and the rights of that contract. You get to choose when to exercise. If you are short an option you have no power and all the obligation of that contract. You do not get to choose when you are assigned.

Don't exercise an out-of-the-money option and only exercise before expiration if there is a sizable dividend involved. If you are short options always be mindful if your option is in-the-money. You don't want to wake up and realized you've been assigned so now you are either long the shares (short put) or short the shares (short call).

How do you like to close out your options? Tell us in the commnents...

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