EXERCISE VS ASSIGNMENT IN OPTIONS TRADING

Understanding Option Exercise and Assignment

Options trading involves specific terms and processes that can greatly affect the outcome of an investment. Among the most important of these are exercise and assignment. Though they are closely related and often confused, these two concepts represent different actions that occur during the lifecycle of an options contract. Understanding the difference is crucial for anyone involved in trading or hedging with options, whether you are a beginner or an experienced investor.

In simple terms, exercise refers to the action undertaken by the holder of an option. If the holder of a call option wants to buy the underlying asset at the strike price, or if the holder of a put option wants to sell the underlying asset at the strike price, they may choose to exercise their rights under the contract.

Assignment, on the other hand, is what occurs to the writer (or seller) of the option once the holder has exercised it. In the case of a call option, the writer must sell the underlying asset at the agreed strike price, while for a put option, the writer must buy the underlying asset at the strike price.

Understanding when and how these events occur involves knowing how American and European style options work. American options can be exercised at any time before expiry, while European options are only exercisable on the expiration date. As a result, the occurrence of exercise and assignment with American options can be more unpredictable.

This article will explore the definitions, differences, examples, and practical applications of option exercise and assignment, outlining when each event typically happens and its implications for traders.

What Is Option Exercise?

Option exercise is the right of the holder of an options contract to buy or sell the underlying asset at the agreed-upon strike price. This is a conscious decision by the options holder and is only applicable when it makes financial sense – typically when the option is in the money.

How Exercise Works

When an investor purchases an option, they are buying a contract that gives them the right, but not the obligation, to engage in a transaction on the underlying asset. If the investor chooses to act on that right, this is termed as exercising the option. For example:

• If they hold a call option, exercising allows them to buy the asset from the option writer at the strike price.
• If they hold a put option, exercising enables them to sell the asset to the option writer at the strike price.

Only the holder, or buyer, of the option may initiate an exercise. The seller of the option cannot exercise – instead, they may be assigned if the buyer chooses to exercise.

When Do Traders Exercise Options?

Options are typically exercised in the following scenarios:

• American options: These can be exercised at any time before expiration, meaning that the holder has flexibility if the market moves in their favour.
• European options: These can be exercised only at maturity, meaning the holder must wait until the expiry date to execute the right.
• Traders are likely to exercise options at expiration if the option is in the money (e.g., a call option with a strike price below the market price or a put option with a strike price above the market price).
• Options may also be exercised early for specific strategic reasons, such as dividend capture or tax considerations.

Costs and Considerations

Exercising an option may involve transaction costs, and it means the holder must either pay for or accept delivery of the underlying asset. This is why many traders opt to close their position by selling the option in the market rather than exercising it directly. Still, in certain cases, direct exercise provides better financial or strategic outcomes.

In brokerage accounts, exercise typically takes place automatically for in-the-money options at expiration unless the holder instructs otherwise. This is known as automatic exercise.

In summary, exercising an option is a voluntary action made by the holder, when profitable or otherwise necessary. It requires action before (American style) or on (European style) the expiration date and results in the physical or cash settlement of the underlying asset at the contract’s strike price.

What Is Option Assignment?

Option assignment occurs when the seller (or writer) of an options contract is notified that the buyer has exercised their option. This triggers a fulfilment obligation for the writer: they must buy or sell the underlying asset at the strike price, depending on whether the option is a put or a call.

Assignment Process Explained

When a buyer decides to exercise an option, the financial clearinghouse randomly selects a seller who holds a short position in the same option series. This seller is then assigned – a mandatory process that compels them to honour the contractual obligation under the terms of the option.

• Call option: The assigned writer must sell the underlying shares at the strike price to the exercising buyer.
• Put option: The assigned writer must buy the underlying shares at the strike price from the exercising seller.

Assignments are typically handled automatically by brokerage platforms, and traders with short positions must be aware of the potential for assignment, especially as expiration approaches.

When Does Assignment Happen?

Assignment can happen at any time if the option is American style, even before expiration. For European-style contracts, assignment only happens upon expiration. Key factors influencing assignment include:

• Option moneyness: In-the-money options are candidates for exercise, increasing the assignment risk for writers.
• Time to expiration: Writers are more likely to be assigned as expiry closes in and the option remains in the money.
• News events/dividends: In the case of call options, early exercise (leading to assignment) may happen before dividend ex-dates to capture dividends.

Financial Implications for Writers

Being assigned may result in financial obligations or the need to deliver cash or securities. This is especially important in margin accounts where sufficient capital must be maintained to meet assignment obligations. Depending on the strategy employed, assignment can either be expected (as in a covered call) or unwanted, leading to potential losses or the need to adjust a position.

To manage assignment risks, traders may choose to unwind their positions before expiry, roll options into future periods, or hedge using complementary instruments.

Tracking and Notifications

Brokerage platforms typically notify clients of assignment via trade confirmations or account statements. Still, assignments can come as a surprise to the unprepared trader. Close monitoring and awareness of option status, especially for short options approaching expiry, is advisable.

To summarise, option assignment is a mandatory action affecting option sellers once buyers decide to exercise. It can involve selling or buying the underlying asset and represents a key consideration in risk management and trading strategy.