Last Update: August 2021
The assignment hobgoblin has been haunting the dreams of novice traders since the dawn of the options market. At first, he’s hidden. Traders tackling the basics of call and put buying remain oblivious to his existence. At some point, most dollar seekers tire of the frequent losses that beset them during the game of option buying. That’s when they take up their journey down the learning path eventually venturing into option selling territory. And that, my friends, is where the monster resides. Initially, he’s very mysterious, spooky even. Blame it on the fog. It surrounds him masking his true form. As a result rookie traders’ imaginations go wild.
It’s just like my boy’s favorite bedtime story: A Fly Went By.
It chronicles an exciting animal chase which builds page by page. First, it’s a fly fleeing from a frog. But the frog doesn’t want the fly, no, he’s simply running (hopping?) away from the cat who’s running from the dog. The chasing chain continues (complete with a pig, cow, and fox) until we discover the initial catalyst: A man with a gun running from something scary. Or, at least that’s what his lizard brain is telling him. Like the assignment hobgoblin he’s not really sure what the scary something even is.
Don’t be the man with the gun.
You see, it turns out that bump and thump he heard was merely a little lamb stuck in a can. His fears were unfounded! Should have done a bit more investigating before soiling the trousers, eh, dear hunter?
Allow me to unmask the so-called assignment bogeyman. He’s not all that scary. Quite the contrary he’s often like a profit mailman delivering dollars straight to your doorstep.
Assignment occurs when an option seller is required to make good on their obligation to buy or sell stock. When you sell a call you promise to sell the stock at the strike price. When you sell a put you promise to buy the stock at the strike price. If assignment occurs you simply have to make good on your promise.
No Indian givers are allowed in the options market!
At expiration, assignment becomes automatic for any short ITM options. OTM options simply expire worthless. To avoid assignment you need to buy to close any short ITM options before expiration. But that’s not what most people are worried about. It’s the early assignment that gets their knickers in a twist.
If you’re selling American Style options (pretty much everything but Index options) there’s a chance you could be assigned early. Fortunately, early assignment is incredibly easy to avoid if you simply pay attention. First, you will never be assigned early on a short OTM option. And if you are, then the idiot on the other side of the trade just gave you lots of money.
When budding traders hear that they usually conclude that if their short option moves ITM then early assignment is imminent.
When someone exercises an option – that’s what has to happen for you to be assigned -they lose any remaining extrinsic value (aka time value). As long as there is extrinsic value remaining in the option they won’t exercise. Which means you won’t be assigned, so stop worrying about it. It’s just a little lamb stuck in a can.
Here’s the rule of thumb I suggest: If your short option moves ITM and it loses all its extrinsic value and you don’t want to be assigned, then close the trade.
Now, in the event you are assigned early, don’t panic. It’s not like the market gods just cursed you with massive overnight losses. Most of the time your option position simply turned into a stock position with the exact same unrealized gain or loss. You can usually close the stock position and incur the same gain or loss you would have incurred by simply closing the option trade the day prior.
If you’re picking up what I’m laying down at this point, you’re good to go. Run along and play. If you need an example, read on
USO is trading for $11.20. I originally sold the Jan 12.50 put for 50 cents. With the put now worth $1.30 my current unrealized loss is 80 cents per share, or $80 total. Take note, the put has no extrinsic value at this point. It’s trading at parity as the cool kids say.
Suppose I was unexpectedly assigned and the next day I wake up long 100 shares of USO. I had to buy the shares at the $12.50 strike, but because I received 50 cents premium upfront my cost basis is actually $12. With the stock at $11.20, my unrealized loss is still 80 cents per share, or $80 total. See, nothing changed with my profit/loss even though I was assigned. The only difference is I now have to sell the stock to incur the $80 loss and close the trade whereas the day before I would have had to buy to close the put to exit the position.
We could also illustrate the equivalency in position by looking at the delta. Since my short 12.50 put had no extrinsic value it was probably deep enough ITM to have a +100 delta. If that short put turns into a long 100 share position via the assignment process, guess what? My delta is still +100. So my directional exposure hasn’t changed at all. If the stock rises or falls I’ll incur the same gain or loss in the stock position that I would have in the short put position.
The same takeaway applies if you were short a call.
Assignment hobgoblin unmasked, mystery solved, case closed. Huzzah!
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