Exercise and Assignment

Why this matters

The lessons so far have treated an option as a price on a screen. Behind the price is a contract that can be put into effect: shares change hands, thousands of dollars move, and one of the two parties usually doesn't choose when. A writer learns about it from a notice in their account. Many unpleasant surprises in options come from here, to people who understood the payoff diagram and didn't know the mechanics. The details below are for US listed options.

Three ways an option ends

Before its expiration date, the holder of an option can do one of three things: sell the contract to close the position, exercise it, or let it expire.¹ Most options end the first or the third way. FINRA puts the share of options positions that are exercised at only about 7%.²

The reason was in the last lesson. Exercising collects an option's intrinsic value and nothing more. Selling it collects the intrinsic value plus whatever time value is left. As long as any time value remains, selling pays better than exercising.

Exercising

To exercise, a holder gives instructions to their brokerage firm, following the firm's procedures and before its cut-off time, which can differ from firm to firm.³¹ When that can be done depends on the option's style.³

• An American-style option can be exercised at any time before it expires. Options on individual shares and exchange-traded funds are American-style.¹
• A European-style option can be exercised only at expiration.

The names have nothing to do with geography. What's delivered also varies. With a physical delivery option, exercise means the shares themselves are bought or sold. With a cash-settled option, the holder receives a cash payment based on the difference between the value of the underlying interest and the strike.³

Exercising a call takes money. One contract with a $50 strike means buying 100 shares for $5,000, however little the option itself cost.¹ Exercising a put means selling 100 shares at the strike. A holder who doesn't own them ends up with a short position in the shares, as described in Margin and Short Selling.

Assignment

When a holder exercises, some writer has to perform. Which one? It isn't the person the holder happened to buy from. Options of the same series are interchangeable, so the system picks.

1. The Options Clearing Corporation randomly assigns the exercise notice to a brokerage firm that has customers who are short that option.
2. The firm assigns it to one of those customers, at random or by another procedure the firm has set.
3. That customer, now an assigned writer, has to meet the contract's terms.

This is FINRA's description of the process.² The assigned writer of a call must deliver the shares. The assigned writer of a put must buy them at the strike price, whatever they're worth in the market.³

Position written	STU when assigned	What the writer must do	Premium kept	Result
One $45 put	$38	Buy 100 shares for $4,500 that are worth $3,800	$150	−$550, and now owns the shares
One $55 call, owning 100 shares bought at $50	$62	Sell the shares for $5,500	$200	+$700, and gives up the rise above $55
One $55 call, owning no shares	$62	Buy 100 shares for $6,200 and deliver them for $5,500	$200	−$500

The put writer needed $4,500 available on the day. A writer whose account can't cover an assignment may have positions closed by the brokerage firm.¹

It can come at any time

A writer of an American-style option can be assigned on any day the option is open, from the day it's written until it expires or is closed out.³ Most exercises and assignments happen at or near expiration, and still a holder can exercise at any time.² The writer doesn't decide and isn't asked. The only way to end the exposure is to buy the option back in a closing transaction.

The rest of this lesson is for members

Still to come in this lesson: When early exercise makes sense, Expiration, When the shares change, the key takeaways, and 2 quiz questions with explanations.

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