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The options expiration and assignment process can often be confusing for new options traders. In this article, we will clearly explain the entire options expiration and assignment process to give you the knowledge and confidence to get started in options trading.
Option contracts have a finite life. There is a specified time in the future when that option contract will no longer exist. Unlike stocks, which are perpetual as long as the company stays in business, option contracts are temporary agreements.
Option buyers have the right to exercise their options contacts, while option sellers are automatically assigned stock based on the decision of the option buyer.
Let’s say you bought a 50-strike put option and the current stock price is $45. In this case, you would want to exercise the option contract so that you can sell the stock at a greater price of $50 per share instead of $45 in the open market.
Only in-the-money options, or options with intrinsic value, would ever be exercised. Out-of-the-money options would never be exercised because they have no intrinsic value. If the option is out-of-the-money, you would be better off transacting stock in the open market rather than through the option contract.
In this example, you would want to exercise the put contract. To exercise the put contract, you would contact your brokerage firm and let them know that you would like to exercise the option contract. The brokerage firm would then notify the Options Clearing Corporation (OCC) of your request and then the OCC would put or sell 100 shares of stock from your brokerage account per your request.
The OCC is a government regulated company that acts as an intermediary to guarantee all option contract transactions. They exist so that if any option buyer wants to exercise his or her contract, there will be someone on the other side to make good on the contract.
However, the OCC is not the one giving you the shares; it is only acting as a middleman in the transaction. After taking 100 shares of stock from your account, the OCC would then randomly select a brokerage firm and account within that brokerage firm that has sold that 50-strike put option. That randomly selected account would then be assigned, meaning they would have to buy stock from the OCC to make all parties whole. That person who sold the 50-strike put now has the obligation to buy 100 shares of stock at a price of $50 per share.
There are two styles of exercise and assignment. American style options can be exercised at any time prior to expiration. The second type is European style options. European style options can only be exercised during a specified period of time prior to expiration – typically the Thursday or Friday before expiration.
Because American style options have greater flexibility in when you can exercise the contract, they will have more value than European options. However, this does not mean one is better than the other in terms of trading.
Most, if not all, stock options are American style, while indices like SPX and VIX are European style.
The second distinction we have to make is between physical and cash settlement. Up to this point, we’ve explained physical settlement. This is when option buyers buy or sell actual stock to settle the contract. In cash settled options, however, the option contract settles to the cash value of the underlying asset instead of the physical asset.
In our previous example with the 50-strike call option, if it were physically settled, there would be 100 shares of stock changing hands. If it were cash settled, only the cash value of the shares would change hands.
Most, if not all, stock options are physically settled, while indices like SPX and VIX are cash settled.
If you are confused on any of the terms used here, we have a full list of option trading terms here.
The short answer is no.
If you bought an option that now has intrinsic value, one path would be to exercise the option contract to stock as we explained earlier. The second path would be to close your option position all together.
To close an option position, you would make an equal but opposite order, netting your position to zero. For example, to close the 50-strike put option that you had bought, you would create an order to sell a 50-strike put option. Those two positions offset one another, “closing” your position. If the price at which you sold the option contract is higher than the price at which you bought the option contract, you would realize a profit at that time.
Typically, newer traders are scared of exercise and assignment because of all the uncertainty. However, this is not really something to worry about as an options trader. One common misconception is that once an option goes in-the-money (gains intrinsic value) it is automatically exercised. This is rarely the case. There is still extrinsic value, or time value, in these options contracts, so if they are exercised early, the option buyer would lose that value.
In fact, only 7% of all options contracts are ever exercised. Of the 7% that are exercised, the majority are exercised in the few days prior to expiration. With the options strategies we use, we are typically out of positions well before expiration (21 days to expiration) so the risk of exercise and assignment is close to zero.
Another concern for newer traders is: what if they don’t have enough money in their account to transact 100 shares of stock? Let’s look at our earlier example. The option buyer wants to exercise the 50-strike put option to sell 100 shares of stock at a price of $50 per share. As an option seller, you would have to buy 100 shares of stock at a price of $50 per share. To buy those shares are you are obligated to, you’d need $5,000.
However, if you don’t have enough money in your account to buy those shares, the brokerage firm will lend you the money for a short period of time. During that time, the brokerage firm will require you to either add more money into your account to cover the purchase of the share, called a margin call, or you will have to close the position (i.e. sell the 100 shares to the market).
Exercise and assignment can be a complex process, but it rarely occurs affects the options that we trade. Here we have outlined the basics of options exercise and assignment and cleared up a few misconceptions the process to bring you more confidence in trading.
If you learned anything about the options expiration and assignment process, let us know in the comment section below!
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