Know what you're getting into before putting on that option trade—avoid surprises by educating yourself about the risks and oddities of assignment.
Fortune cookie says, “Pay close attention.” Maybe your hairdresser was drunk, but you ignore the results. Or, half asleep, you buy a case of tube socks on TV even though shipping fees cost more than the product. Or you bravely concoct Alfredo sauce with no recipe (’cause your mom could). In the long run, ignorance can be tricky. Like getting assigned on a short option. If you’ve ever held a short option position through a covered call, or iron condor, you know there’s a risk of early assignment—i.e., you could be forced to buy or sell stock when the short option you sold is exercised. Instead of guessing when you might get assigned on a short option position, let’s explore the science behind “early exercise” so you can potentially get ahead of the unexpected. (And learn to put down the remote.)
You know that an option gives you the right but not the obligation to buy or sell stock at a set price. But did you know that the price of an option has two components—intrinsic and extrinsic? In the case of exercising an in-the-money (ITM) long call, you buy the stock at the strike price, which is lower than its prevailing price. In the case of a long put that isn’t being used as a hedge for a long stock position, you short the stock for a price higher than its prevailing price. You’ll only capture an (ITM) option’s intrinsic value if you sell the stock (after exercising a long call) or buy the stock (after exercising a long put) immediately upon exercise. If you don’t, you take on all of the risks associated with holding a long or short stock position. So, the question of whether a short option might be assigned depends on if there’s some perceived benefit to another trader exercising a long option that you happen to be short.
Fortunately, there’s a method to the madness.
When you’re short an option, you need to put yourself in the shoes of the person who’s long that option. Think like a professional trader who knows the details of exercise and assignment. If you’re short an option that’s ITM, the other trader who’s long the option might exercise it. If it’s out of the money (OTM), it’s less likely. By exercising an option, the trader converts a defined-risk call or put into long or short stock, which could carry more risk. So, the other trader will likely want to hedge that stock by creating a synthetic. In the options world, synthetics are constructed from a short list of elements: calls, puts, and stock. Say a trader exercises a long call and takes delivery of long stock. Let’s say he then buys a put at the same strike as the call he just exercised to create a synthetic long call. If a trader exercises a long put, he creates a short position, i.e., deliver stock you don’t own. He’ll likely buy a call at the same strike as the long put he just exercised to create a synthetic long put. If you want to see if an ITM short option might be assigned, you have to look at the corresponding OTM option at the same strike (Figure 1).
FIGURE 1: WHAT IF YOU GET ASSIGNED?
Check out the value of an OTM put and ITM call of the same strike price. If you’re trying to see whether your short ITM call might be assigned, compare the price of the OTM put to the expected dividend. Source: thinkorswim by TD Ameritrade. For illustrative purposes only.
Because the synthetic option contains long or short stock, capital requirements for the synthetic position could be considerably greater than those for the long call or put option.
Let’s look at the cash flows around exercise and synthetics. If you exercise a long call, you have to pay for the stock with cash from your account. Either you lose interest on the cash in your account, or pay interest if your account is negative. For example, if you exercise a long 30-strike call with 10 days to expiration and the interest rate is 2%, the interest would be ($30 x 0.02 x 10)/365 = $0.0164. Note that the interest isn’t calculated on the $3,000 the strike represents. That’s because you want that interest number to be in terms of the option’s price.
Next, look at the price of the 30-strike put with 10 days to expiration. To create the synthetic long call, you’d have to buy that put. If the 30-strike put is trading for $0.20, you’d pay $20 for it. But like interest, you’d use only the $0.20 put price in your analysis. Add the cost of the interest to the cost of the put to get the cost of exercising that call, which in this case is ($0.0164 + 0.20 = $0.2164).
Say the 30-strike call is trading for $2.25 with the stock trading at $32. If the trader exercises that call, he’s giving up that $0.25 of extrinsic value. And if you add in the $0.2164 to create the synthetic equivalent call, it means exercising that call doesn’t make much financial sense.
Hang in there, because life gets interesting when stocks pay a dividend. If the dividend is greater than the cost of the interest plus the cost of the 30 put plus the cost of any lost extrinsic value, then there may be a financial advantage to exercising the call. This usually happens close to the ex-dividend date. A trader would have to exercise that long call on the day before (or earlier than) the ex-dividend date to be eligible to receive the dividend. You should monitor your short calls closely, especially as the dividend date approaches. Know how much the dividend is, how much extrinsic value your short calls still have, and the premium value of the corresponding OTM put.
You can do it all on the Trade page of the thinkorswim® platform from TD Ameritrade. You can see past dividends, the price of your short call, and the price of the put at the call’s strike price. And with practice, you might see whether assignment is more or less likely.
If you have a covered call that’s ITM and it’s assigned, you’ll deliver the long stock out of your account to cover the assignment. And you’ll have to pay the assignment fee.
If you have a call vertical where both options are ITM and the ex-dividend date is approaching, you may want to exercise the long option component before the ex-dividend date to have long stock to deliver against the potential assignment of the short call. You may end up paying two exercise/assignment fees. Or you could close the ITM call vertical before the ex-date. It might be cheaper to pay the commission to close the trade.
If you have a call vertical where the ITM option is short and the OTM option is long, you may want to consider closing the position or rolling it to to a further expiration before the ex-date. You’d do this to avoid having short stock on the ex-date and being liable for the dividend.
So, if you’re long an ITM call, it may be better to close it ahead of the ex-date rather than exercise and create the synthetic. That’s because on the ex-date, the price of the stock drops by the amount of the dividend. The drop in the stock price offsets what you’d earn on the dividend, and you’d still have to pay commissions and fees on top of the price of the put.
Make every attempt to get nerdy and shrewd about early exercise. And avoid potential surprises like “European-style options"—they’re typically associated with indices and can only be exercised at expiration. As you know, you can’t own an index. So an index option can only settle to cash, not a tangible product. Going further, cash settlement means that if you own an option that expires ITM, you get the difference in cash between the stock and strike price. If you’re short the option, you must pay the difference. Most indices trade European-style options and are cash settled. One exception is the OEX (index options traded on the Standard & Poor’s 100 Index), which has its own rules.
When your option is converted to stock through exercise or assignment, your position’s risk profile naturally changes. This could increase your margin requirements, or you may be subject to a margin call, or both. This can happen at or before expiration during early assignment. Ironically, exercise of a long option position can be more likely to trigger a margin call, since naked short option trades typically carry substantial margin requirements.
Early exercise can be tricky, and you can still be assigned on a short option any time prior to the option’s expiration, even if you think there’s no financial benefit for doing so. Educate yourself fully about “early” anything. And never wear those tube socks first thing in the morning. Tube socks should only be assigned after hurricanes and nasty basement floods.
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