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Understanding Options: Exercise & Assignment

As an educator in the field of options trading, I’m often asked “what causes a short call or a short put to be assigned?” Before I can answer that question I need to briefly explain what an option is, some of the terminology used, and who the participants in the exercise and assignment process are. Lastly, this discussion pertains to the American style options. These are the type of options that most of us buy and sell. They are the type of options that you would see for most equities like Apple or American Airlines. The other style of option, which we will not be covering in this discussion, is the European style option. Those options do not provide for the buying or selling of the underlying itself. They settle at expiration in cash only.

Let’s look at the basics of exercise and assignment from a theoretical perspective. In the most basic sense, options are an agreement between two parties. That agreement provides the owner of the option the right to do something. The seller of that same option is therefore obligated to fulfill the rights of the long option holder. The buyer of a long call option is purchasing the right to acquire the underlying equity for a specific price for a certain amount of time. If it is in his or her best interest financially to exercise their right than they would do so. This is known as exercising an option.

When an investor sells that same call option, they are paid a premium which is deposited into their brokerage account. At the same time, they have an open obligation to fulfill the rights of the long call option holder. If the long call option holder decides that it is in their own best interest to exercise their rights and to buy the underlying, then the short call seller would be obligated to provide the underlying to them. This is referred to as assignment.

In the case of a put option, the investor who buys a long put is purchasing the right to sell the underlying equity for a specific value for a specific amount of time. That means that if the long put holder decides that it is in their best interest to exercise their put the short put seller would be assigned and therefore have to buy the underlying equity.

Once an options contract is opened it can be exercised 24 hours a day, seven days a week. Opening or closing an option contract is quite different than exercising one. Options are opened through an exchange (like the Chicago Board of Options Exchange). They can be closed in several different ways:

1. The option can simply expire worthless at expiration
2. It can be closed by placing an order with the brokerage which is sent to one of the member exchanges
3. It can be exercised which would trigger the assignment process which would also close the option

In the first scenario above if the option is out of the money and options expiration, it would simply cease to exist and would be removed from your portfolio.

In the second scenario, you would actively send in order through your brokerage which would be routed to one of the member exchanges to close it.

The parties that are involved in the exercise and assignment process go beyond your brokerage.

In the third scenario, the long option holder is simply exercising their rights and therefore does not need an exchange. So who does the actual administrative functions to exercise and assign an option? That task would be carried out by the Options Clearing Corporation (OCC). Here’s a little bit of information about the OCC: All of the options exchanges (CBOE, Philly Exchange, Pacific exchange, etc.) are charter members of the OCC. The OCC creates the rules and bylaws that regulate and control the buying and selling of options as well as the assignment and exercise process. The member exchanges can be thought of as simply a marketplace where buyers and sellers are brought together to open a contract or to close a contract. The exchanges have no role in the actual rights and obligations of the options instrument. That process belongs to the OCC.

When a long option owner decides to exercise their rights, they would tell their broker to do so. Since we’re not talking about negotiating to open or close a contract but rather simply exercising the rights of the contract, there is no need for a marketplace or exchange so the order goes directly to the OCC. Once the OCC has the exercise order they randomly select a brokerage who is short that same option. The OCC then sends a notice of assignment to the brokerage. The brokerage in turn, selects one of their accounts at random and assigns them the obligation.

So when exactly do options get assigned? Options assignment can occur at any time once an options contract is opened. At options expiration if an option is in the money by as little as one cent, it will be exercised; with one minor caveat. That caveat is OCC rule 805D and is beyond the scope of this particular discussion. A complete list of the OCC rules can be found here: http://www.optionsclearing.com/components/docs/legal/rules_and_bylaws/occ_rules.pdf

American-style options can be exercised at any time, 24 hours a day seven days a week until they reach their expiration. So what would cause your short option to be assigned early?

It is rare that a short option that is in the money is assigned early, but it does happen occasionally. The most common cause of early assignment pertains to a short call of an equity that is about to go ex-dividend. Keep in mind that the only reason someone would exercise their long call (other than by mistake), would be if it was in their financial best interest to do so. So, in the case of a dividend paying equities, if the dividend itself is greater than the remaining extrinsic value of the in the money call option, it would make sense for the long call folder to exercise their long call, by the stock and capture the dividend. They would forfeit any remaining value in their long call. However, as I indicated above, if the dividend is greater than the remaining extrinsic value of their option, it is in their best interest to exercise their long call.

Short puts do not generally get assigned early. Keep in mind that it requires an active exercise by the long put holder to trigger the exercise and assignment process. While it can happen prior to expiration, it typically does not.

I hope that this brief explanation of the exercise and assignment process helps to clarify your understanding of how options actually work. They are contracts, legal financial contracts with performance rights and performance obligations. Please make sure that you understand your rights and your obligations before entering any trade.

Jeff McAllister
OptionsANIMAL VP of Education

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Jeff McAllister

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