As far as I can remember, I've been assigned stock only once. But I should be sure how many times that had happened, shouldn't I? I'd remember each such scary occasion with perfect clarity, wouldn't I?
Not necessarily. Most option traders imagine that being assigned stock is a more traumatic event than it usually is. They imagine margin calls when they're suddenly presented with 100 shares of stock per contract. They imagine bankruptcy, a ruined trading account, doom.
That's just not the way it works in most cases. There can be times when a big price gap in the underlying at the open the day after your sold call or put has been exercised could cause problems, but those times are rare. There can be rarer problems such as the one I discussed in the January 8 Trader's Corner article, "OEX versus XEO: The Debate Continues." But these are rare happenings. However, I was reminded of the fear associated with an assignment when I read an archived CBOE "Ask the Institute" question and answer.
The question was written from the perspective of an option trader who wanted to exercise calls that would result in physical delivery of the stock. "[C]an I sell the underlying asset in the spot market or do I have to wait three business days for the settlement?" the writer asked. The writer was speaking of the T + 3 settlement date at which ownership of the stock you've purchased is completed, with "T" being the transaction date and "3" being the number of market days after the transaction. "Also, do I need the cash in my account to buy the stock at the strike price or [after I sell the stock] will I receive the difference between the strike price and spot price (assuming it's in the money)?"
The CBOE expert answered, assuring the writer that there was no need to wait for the T + 3 settlement date for the underlying shares of stock to sell those shares. They could be sold immediately. Neither did the call buyer need to have enough money in an account to pay for the purchased stock as long as it was immediately sold. Both transactions would be completed on the T + 3 date. The same T + 3 guidelines prove true in the case of a put seller when the underlying is put to that seller. The put seller who finds herself long stock after an assignment can immediately offset that long position by selling the stock. The same T + 3 settlement date will apply for both transactions.
If the call or put seller also held hedging long call or put positions, those can be exercised. Speak to your broker about whether margin issues will arise in this case. There will be a one-day delay between the two T + 3 settlement dates. Although exercising my own long hedging calls was the manner I used to manage my own situation, I had plenty of cash in my account to cover the position for the extra day, so I am not familiar with how this would impact other traders. The way this would be handled, when one has elected to exercise the hedging option, may be broker-specific anyway. Of course, if a call or put is exercised at expiration, the trader who wakes up the next trading day with assigned long or short stock no longer holds a hedging position and will not be able to exercise that expired option, so be careful as expiration approaches.
If you're assigned stock or have had stock put to you, costs, including buy and sell commissions, will be incurred. However, as should be clear by now, it's usually not the catastrophe most option traders fear.
Here's what happened to me and the choice I made. I'd bought a cheap out-of-the-money SPY call butterfly. It was intended as a speculative trade that I was just going to set and mostly forget. The maximum loss in a butterfly is the amount spent on establishing it, right? Not so, not when there's an ex-dividend date coming up in your underlying, it turns out.
The trade went wrong, but there was still some time premium in those sold calls and I wasn't worried about being exercised. This had been a cheap trade and there was the possibility it could still work. I wasn't worried because I'd forgotten about the sneaky ETF's that have ex-dividend days during opex week every month.
Moreover, the exact amount of the dividend for some of these ETF's may not be clear. It's sometimes hard to determine if the extrinsic value is high enough that the call is unlikely to be exercised just to collect the dividend. The risk of assignment rises on ex-dividend day, when those holding in-the-money long calls exercise them so that they can hold the stock and collect the dividend. With some of the ETF's, you aren't entirely sure if that's likely to happen, even if you do remember the ex-dividend date, which I hope you do after having read this!
So, I found myself short 200 shares of the SPY one fine morning during an option-expiration week. I also held long SPY options. After talking over my choices with my broker, I exercised those long SPY options. This wasn't a choice I would have wanted to make if there had been a lot of extrinsic or time value left in those long options. Net-net, after I exercised my own long calls, I held 0 shares of the SPY. Unfortunately, I had incurred transaction costs and I owed someone dividends on 200 shares of stock. Worse, I was a day late to collect those dividends on the calls I exercised.
But it wasn't a disaster.
There are of course risks for both the person who has sold a call or put that might be exercised and even for the person who elects to exercise a long call or put. The person who wrote the "Ask the Institute" expert incurred costs for buying and selling the stock. The person holding the long call and exercising it expected to sell the received stock for a profit, resulting in the net proceeds being delivered to that person's account. However, it's possible that the stock could have gapped down the morning after that person had chosen to exercise the stock, resulting in a loss rather than a gain from the transaction. Whether that is likely or not depends on many factors, including event risk and other factors.
In certain strategies, such as selling puts on underlyings that the put seller hopes to own at a cheaper price, option traders might sell options hoping that they'll be exercised. The trader employing this strategy gets to keep the credit received when the put is sold. That person also purchases the stock at a lower price than that at which the underlying was originally trading, since the put chosen is usually one with a strike price below the current price at the time the put is sold. However, in many and perhaps most cases, it's likely that the option seller had no intention of letting that sold option be exercised.
Forgetfulness--as was true in my case--or poor trade management constitute the typical reasons that a call or put seller finds that the sold option has been exercised. Call or put sellers who have no intention of letting a sold option be exercised should be aware of whether the sold option is an American-style or European-style option. American-style options can be exercised at any time, so any option that has little extrinsic value is at risk of being exercised. European-style options, such as those on the cash-settled SPX, RUT and XEO, can be exercised only on the date of expiration.
Whatever the style of options, all call or put sellers should be particularly attentive on the last trading day of those options. Long call or put holders will find that their calls or puts are automatically exercised at expiration if stock options are at least $0.05 in the money or index options are $0.01 in the money. BrokersXpress notes that this Automatic Exercise procedure was instituted by the Options Clearing Corporation. It was intended to protect call or put buyers who simply forgot that they had in-the-money options.
Talk to your broker about whether it's possible to abandon those long options you hold that are lingering near the strike price at expiration if you don't want them automatically exercised. To "abandon" these options means to elect not to exercise them. It used to be possible to abandon those options as long as the brokerage was notified by a certain time each day, but I'm not certain if that's still possible since the OCC changed the amount by which an option would be in-the-money when automatically exercised. If it's not possible at your brokerage and you don't want to chance that option being automatically exercised, you must then sell-to-close that long option. Unfortunately, in this situation, that might mean that you end up paying more in commissions than you collect in premium, but some equities jump around enough that the risk is high and some indices have quirky enough settlement values that risk is high there, too. Talk to your broker about your choices if the last trading day finds you with this kind of will-it-or-won't-it decision.
Likewise, if I'd sold an option that was close to the sold strike as the last trading day neared, I'd pay a debit to close any sold option unless it was one I hoped to have exercised, such as if I wanted stock put to me at a cheaper price. What value constitutes "close to the sold strike" can vary greatly, as index settlement values can be wildly far away from their close on the Thursday or Friday (in the case of OEX options) of opex week. For GOOG, "close to the sold strike" is probably very different than it might be for the more staid GIS, too.
Conversely, if your long stock option is less than $0.05 in the money and you want to exercise it, you must specifically request that it be exercised, making that request by the close on the last trading day.
Whether it makes more sense to exercise a call or put or just sell it in the open market requires some computations. So does making the decision about whether you'll buy back a sold call or put if you don't want it assigned. Those computations involve calculating the carry costs that would be required to own the stock. For example, if you're thinking about exercising a long call position so that you can collect the dividend, but carrying costs of owning the stock (borrowing the money to pay for the stock, etc.) are more than the dividend, then it doesn't make sense to exercise the option. Under these conditions, if you sold the call, you're not likely to find that short call assigned, either. Your broker should be able to help you make these computations using current carry cost figures, but a rough formula for the carry costs would be [(cost of stock purchase)*(interest rate)*(period the stock will be held)/360].
Some experienced option traders suggest you look at the bid of the opposite option at the same strike to judge assignment risk if you've sold options. This relates to whether it's cheaper for the long option holder to exercise the call or put or create a synthetic position. Synthetics is a topic suitable for a whole series of articles, but Mike Tosaw of BrokersXpress dispatched this whole discussion quickly in a Web-ex presentation for BrokersXpress. For example, if you've sold a call and the bid on the put is less than $0.05, then there's a greater risk of assignment before expiration, he warned in that BX presentation.
Obviously, I've glossed over several aspects of exercising and assigning options, aspects that would require separate long articles of their own. The point of this article was two-fold: to reassure option traders that neither exercising options or being assigned on options is inevitable or traumatic and to point out matters that might need to be clarified with your brokerage. Speak to your broker or the trading desk at your brokerage, if you don't have an individual broker, about how such issues are handled where you trade. Many online brokerages offer webinars about exercise and assignment that will point to specific procedures at your brokerage. The Options Industry Council, the educational arm of the OCC, offers free classes that delve into exercise and expiration considerations, available for those who want to learn about these issues in more depth than I can cover in a single article.