Option Exercise and Assignment: Beginner’s Guide

What is Exercise and Assignment?

An option is a derivative, meaning it has no inherent value by itself. To capture value, long option contracts are either sold in the open market for cash or 'exercised' and converted into stock, or whatever underlying asset the option is tied to.

Long option holders, which include calls and puts, have the right to convert their options into the underlying asset. When they choose to do this, they are 'exercising' that right.

For every long call or put option, there is a corresponding short position. For instance, if a long trader exercises their 100 strike price call stock option, they receive +100 shares of stock the next trading day at $100/share.

But who provides those shares? The short does. The short will be left with a flat option position and -100 shares of the underlying asset in their account the day after the long exercises. The specific short is selected at random, which we’ll cover later.

Here’s what happens to both long and short positions when exercise or assignment occurs for both calls and puts:

Calls & Puts: Exercise and Assignment

• Call Option (Exercised): Buyer acquires the underlying asset at the strike price.
• Call Option (Assigned): Seller must deliver the underlying asset at the strike price.
  
  
• Put Option (Exercised): Buyer sells the underlying asset at the strike price.‍
• Put Option (Assigned): Seller must buy the underlying asset at the strike price.

📖 Mastering Option Chains

Exercise Assign Process

Here is what happens behind the scenes when an options contract is exercised and assigned. 

1. Long exercises call/put
The holder of a long call or put option notifies their broker of their wish to exercise their right to convert their contract to the underlying assets, usually by clicking a button on their trading platform. 

2. Broker processes exercise through OCC
The broker forwards this notice of exercise to the Options Clearing Corporation (OCC), who in turn begins the process of finding a corresponding short position to match the exercise request.

3. OCC & Broker Randomize Assigned Option Account
To ensure fairness, the OCC randomly assigns the exercise request to a broker with short positions. The broker then randomly selects an account holding a short position to fulfill the obligation.

4. Short is assigned
The short is assigned the obligation to fulfill the terms of the exercised contract. This notice is typically done via email.  

5. Stock or cash transfer completed
The necessary transfer of stock or cash is executed, typically before the market opens the proceeding trading day. 

Before getting further into the nuts and bolts of the exercise/assign process, let’s cover a few basics that are essential to understanding how it all works

American vs European Options

When we talk about option assignment and exercise, we generally use the term ‘underlying asset’ instead of stock. This is because not all options are stock options. For example, one of the most highly traded products in the world, SPX (S&P 500 Index), doesn’t even offer an actual underlying asset to trade.

So, how are these options settled? Through cash settlement. It’s also important to note that index options can’t be exercised early. Popular index options like SPX, NDX, and VIX fall under the European-style category, meaning they can only be exercised at expiration.

This differs from American-style options, which can be exercised at any time. Most stocks and ETFs fall under this category because they have tradable underlying products. These options are settled through physical delivery, meaning the actual underlying stock will appear in the account if and when the option is exercised or assigned.

Most examples in this article will use American-style options by default unless otherwise stated. 

Longs and Shorts: Rights and Obligations

Long option contracts have the right, but not the obligation, to exercise their options contract. For American-style options, this means they can exercise at any time.

As we covered earlier, when a long exercises their option, the corresponding short gets assigned. The short that’s assigned is chosen at random by the OCC (Options Clearing Corporation). Shorts have no control over this—they must either deliver the underlying asset in the case of a call, making them short, or buy the asset if it's a put, leaving them long.

Short positions need to be monitored closely to avoid unexpected assignments. That said, usually only in-the-money options get assigned. For example, why would a long call holder exercise their right to buy stock at a strike price of 102 if the current market value of the stock is $100?

Intrinsic and Extrinsic Value

Intrinsic and extrinsic value together make up the price of an option. Intrinsic value is simply how much an option is in-the-money. Extrinsic value represents everything else, mostly comprised of time and implied volatility. 

For example, if an option is trading at a premium of $5 and is in the money by $4, the remaining $1 must be the option’s extrinsic value.

At expiration, when there is no time left, an option has zero extrinsic value. This means the option’s value is purely its intrinsic value—assuming it’s in-the-money. If the option is out-of-the-money on expiration it will have no value and expire worthless. 

This is important for exercise and assignment because the less extrinsic value an option has, the more likely it is to be exercised and assigned.

Moneyness & Exercise/Assignment

Generally speaking, only in-the-money options are exercised. Here’s a refresher on how to determine moneyness before we move on:

• In-the-Money (ITM): A call is ITM when the stock price is higher than the strike price; a put is ITM when the stock price is lower than the strike price.
  
  
• At-the-Money (ATM): Both calls and puts are ATM when the stock price is close to or equal to the strike price.
  
  
• Out-of-the-Money (OTM): A call is OTM when the stock price is below the strike price; a put is OTM when the stock price is above the strike price.

Short Options: Assignment Risks

There are three red flags to look for if you’re concerned about a short option being assigned. 

1. The option is in-the-money

The further an option goes in the money, the less extrinsic value it has. Deep-in-the-money options are comprised completely of intrinsic value. Since intrinsic value mirrors the underlying asset price, long option holders may decide to exercise because holding the option mimics holding the stock.

2. Expiration is approaching

The extrinsic value of an option decays as expiration approaches. At the moment of expiration, there’s no extrinsic value left. As we’ve learned, options with little extrinsic value are more likely to be assigned. In the days leading up to expiration, it’s crucial to monitor all short in-the-money options for potential assignments.

3. There is an upcoming dividend. 

Owning equities comes with rights, like the right to receive dividends (if the company issues them). Options, however, don’t carry these rights. Many long in-the-money call options are exercised before the ex-dividend date so the holder can receive the dividend by owning the stock. If you’re short an in-the-money call before the ex-dividend date, it’s best to trade out of the position to avoid the risk of being assigned.

💡Pro tip: For the above reasons, selling index options (European-style options) is especially appealing to traders. Since indices don’t pay dividends and their options can’t be exercised early, many risks associated with option selling are minimized.

Long Options: Exercise Risks

Since long option holders can choose when to exercise (American-style), their risks are generally lower than the risks of option sellers. However, holding long options still comes with its own risks, including opportunity cost. Here are two key risks to be aware of:

1. Not exercising/exiting before a dividend

Following the ex-dividend date, the price of the stock typically falls by the amount of the dividend. This means the price of a call option will likely decrease as well. If you don't exit your call option or exercise it before the ex-dividend date, you’ll miss out on the dividend and incur a potential loss from the stock’s price drop. 

⚠️ This does not apply to put options since short stock doesn’t receive dividends.

2. Auto-Exercise Risk

The vast majority of brokers automatically exercise any long options that are in-the-money at expiration, unless you instruct them otherwise.

For example, let’s say you’re long a 100 strike price call option on ABC. In the final seconds of trading, ABC rallies from $99/share to $100.25/share, meaning your option closed in the money at expiration. Since most brokers automatically exercise in-the-money options, for American-style options, this would result in you owning 100 shares of stock per contract the next trading day, costing you $10,000 for a one-lot position.

If you don’t have the funds to hold the stock or simply don’t wish to, it’s important to instruct your broker of your wishes not to exercise as soon as possible.

⚠️ Exercising or being assigned options typically incurs a broker fee. It’s also crucial to account for the commissions and fees associated with most options transactions as these costs can significantly impact overall returns.

How To Avoid Being Early Assignment

To eliminate the risk of a short in-the-money option being assigned early, you have two options:

1. Exit the position in the open market.
2. Trade European-style options. 

When Should I Exercise My Option?

In 18 years of trading options, I have never exercised a long options contract before expiration. I have been exercised/assigned on index spreads such as SPX going into expiration, but since index options are cash-settled, these do not result in a net position.

Since the price of an option generally reflects everything we’ve discussed in this article, the best approach is to simply exit your option position in the open market if you no longer want to be in the trade. This maximizes your flexibility and minimizes costs.

However, if you must exercise an option, ensure that:

1. The option is in-the-money
2. The option has little extrinsic value
3. You exercise before the ex-dividend date
4. The market offers poor liquidity

Intro to Covered Calls

A popular options trading strategy that often results in assignment is the covered call. In this strategy, a trader buys 100 shares of stock and sells an out-of-the-money call. If the stock rallies beyond the call’s strike price at expiration, the trader will be assigned on the short call, canceling out their +100 shares and leaving them position neutral.

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