Navigating exercise & assignment
Exercise & assignment: a cautionary tale
You shake your Magic 8 ball and the screen reads, “Just because you can, doesn’t always mean you should…”
Sage advice, especially when it comes to exercising your options. If you buy calls or puts and decide to do what the option gives you the right to do—buy stock for call options or sell stock for put options—it sets off a process called “exercise and assignment.” Normally, this isn’t the road most traders go down. Rather, most traders open options positions with the intent to close them later for a profit—un-exercised. Let’s break things down and take a closer look at the mechanics of exercise and assignment.
The mechanics of exercise & assignment
When you exercise a long call, you convert your call into stock. You’ll actually get 100 shares of the stock for every call you exercise…along with a bill for the cost of the stock, dictated by the strike of the call you’re exercising. For example, if you exercised a call with a strike price of $50, you would buy 100 shares of the underlying stock at $50 per share, for a total cost of $5,000.
Now, your exercise is someone else’s assignment. A randomly selected person who is short that call option receives a notice that they’ve been “assigned” and are required to sell 100 shares of stock for every option they’re assigned.
If we’re talking about put options, when you exercise your put, you’re selling (“putting,” actually) the stock to someone (also nameless) who is short a put on the other side of the trade. They have to buy it.
This great power to exercise is always in the control of the option owner, except at expiration. At that point, options that are in the money, even by just one cent, will be exercised automatically (this is common, but always check with your broker regarding automatic exercise policies).
The good, the bad, the ugly (of exercising)…
First, here are a few scenarios where exercising might be a good idea.
- You were assigned on the short leg of a spread. (More on this below.)
- You really, really want to buy or sell the stock, and you can afford to.
- The option you own is illiquid and the bid/ask spread (the difference between the bid and the ask) is very wide. If you stand to lose more selling the option than simply exercising, it makes sense to go ahead and exercise. You don’t want to sell an option for less than its real value (the value that’s in the money).
- Sometimes it is worth exercising your long call to collect a dividend. Remember, options owners do not take part in collecting dividends, only stockholders.
Then, here’s why you may not want to exercise.
- Long options are cheaper than long or short stock.
- Long options are lower risk in that only the premium spent is the maximum you can lose when compared to being long or short stock. Even if you can afford the stock position, make sure you want to take on that type of risk.
- You’re simply giving away your money if your option has any time value. Rather than exercise, if you sell your option in order to close, you not only keep that time value, but you can also mitigate the loss due to an early assignment (in the case of a long option that was previously a part of a spread).
- You’re giving away even more money if you exercise an out of the money option. If an option is OTM and you don’t want it anymore, you try to sell it. If there is no value to it, you may want to just let it expire worthless. Who knows, the stock could make a comeback before expiration.
…and now for the Ugly (of Assignment)
Where new options traders can get in a lot of trouble is misunderstanding assignments—particularly when they’re trading spreads, which contain both a long and a short option. Whereas exercising is something you control in a long position, assignment is something that can happen to you at any time while you’re in a short position.
If your short put option goes in the money and you’re assigned, the cash balance in your account might show a large loss equal to the size of the assigned position. If your short call option gets assigned, you might see a short stock position resulting from selling shares you didn’t already own. But fear not! That’s where your long option comes to the rescue.
As soon as you exercise the long option from the spread, you’ll immediately offset the loss, minus the maximum loss of the spread (which is usually the distance between the short and long strikes of the options).
Closing time, time for you to go out…
If you’re speculating with options, exercising is rarely the optimal choice to close your position. However, it’s worth knowing when you should or shouldn’t and what to do when faced with the decision.
If you have a short, deep-in-the-money option and are at risk of being assigned, it’s usually best to close the position and move on prior to expiration. Assignment doesn’t happen all the time, but it’s the reason you never want to “set and forget” about your options trades, particularly spreads with short options. When your short options go in the money, the longer you remain in the position, the greater the chance you have of being assigned.
The Step-by-Step to Exercise
If you need to exercise your long options:
- Open Robinhood, and go to your positions screen by tapping the chart icon in the lower left
- Tap “Exercise,” and follow the instructions
Next up: Risk management
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