Managing Assignment Risk: What to Do When Your Option Gets Exercised
Options trading offers unparalleled flexibility for income generation, hedging, and speculation. However, with the right to buy or sell comes the potential obligation to fulfill a contract. For sellers of options, the most significant operational uncertainty is assignment risk. Understanding what happens when a call option or put option is exercised is paramount to maintaining a healthy trading account and avoiding margin calls.
In this comprehensive guide, we will explore the mechanics of assignment, why it happens, how to predict it using implied volatility, and the steps you must take if you find yourself assigned. Whether you are running a covered call or a complex iron condor, mastering the nuances of assignment is what separates professional traders from amateurs.
Understanding the Basics: Exercise vs. Assignment
To manage risk, we must first define our terms. Exercise is the action taken by the holder (buyer) of an option to invoke their right to buy or sell the underlying asset. Assignment is the process by which the seller (writer) of that option is chosen to fulfill the obligation.
According to the Options Clearing Corporation (OCC), assignment is a random process. When an option holder decides to exercise, their brokerage notifies the OCC. The OCC then randomly assigns that exercise notice to a clearing member (a brokerage firm). The brokerage firm then randomly selects one of its customers who holds a short position in that specific option to fulfill the contract.
The Mechanics of American vs. European Options
Most equity options traded on U.S. exchanges are American-style, meaning they can be exercised at any time before the expiration date. This creates the possibility of early assignment. In contrast, European-style options (typically found in index products like SPX or NDX) can only be exercised at expiration. If you are trading individual stocks like AAPL or TSLA, you are always subject to the risk of being assigned prior to expiration.
Why and When Early Assignment Occurs
Many novice traders believe that as long as an option has time value, they won't be assigned. While it is true that it is usually mathematically suboptimal for a buyer to exercise early (because they forfeit the remaining extrinsic value), there are specific scenarios where it becomes highly likely.
1. In-the-Money Options and Dividends
This is the most common cause of early assignment for short calls. If a stock is about to pay a dividend, call holders may exercise their in-the-money options to capture the dividend. If the dividend amount is greater than the remaining theta (time value) of the option, the holder has a financial incentive to exercise early. As a seller, you must monitor the "ex-dividend" date closely.
2. Deep In-the-Money Puts and Interest Rates
For put options, early assignment often happens when the option is deep in-the-money and the extrinsic value is negligible. In a high-interest-rate environment, the holder of a put may want to exercise to receive cash immediately (from selling the stock) so they can earn interest on that cash, rather than holding a put option that isn't gaining value.
3. Lack of Liquidity
Sometimes, a trader may exercise an option simply because the bid-ask spread is so wide that they cannot exit the position profitably by selling the option back to the market. By exercising, they bypass the option premium spread and deal directly with the underlying stock.
Managing Risk Before Assignment Happens
Proactive management is the best defense against unwanted stock positions. By monitoring specific Greeks and market data, you can often predict when assignment is imminent.
Monitoring Delta and Extrinsic Value
As an option moves deeper into the money, its delta approaches 1.00 (for calls) or -1.00 (for puts). Simultaneously, the extrinsic value (time value) decays. When the extrinsic value of a short option is less than the transaction costs or the dividend amount, assignment risk is at its peak. You can use tools like the strategy builder to model how your Greeks will change as the stock price moves.
Closing or Rolling the Position
If you want to avoid assignment, the simplest method is to close the short position before it reaches expiration or before an ex-dividend date. If you still have a directional bias, you might consider "rolling" the position. Rolling involves buying back the current short option and selling a new one with a later expiration date or a different strike price. This allows you to collect more premium and potentially move the strike further out-of-the-money.
What to Do When You Are Assigned
So, you woke up and saw a massive change in your account balance? Don't panic. Here is the step-by-step process for handling an assignment.
Step 1: Identify the Position
Check your trade history or "Positions" tab. If you were short a call and got assigned, you will now be short 100 shares of the stock for every contract assigned. If you were short a put, you will now be long 100 shares of the stock. Your account will also reflect the cash exchange: you receive cash for selling shares (call assignment) or spend cash to buy shares (put assignment).
Step 2: Check Your Margin and Buying Power
Assignment can lead to a "Margin Call" if you do not have enough equity to hold the resulting stock position. Brokerages typically require more capital to hold 100 shares of stock than they do to hold a short option. If your account is in a deficit, your broker may liquidate your positions automatically. You should consult FINRA's guides on margin to understand your obligations.
Step 3: Decide on a Disposition Strategy
You have three primary choices after assignment:
- •Hold the Stock: If you were running a wheel strategy and were assigned on a cash-secured put, you might be happy to hold the stock and start selling covered calls against it.
- •Sell/Cover the Stock: If you do not want the stock, you can simply sell the long shares (or buy back the short shares) at the market opening. Note that you are subject to the gap risk between the previous close and the market open.
- •Synthetically Exit: You could sell a call against your new long shares or buy a put to hedge, though most traders prefer to simply exit the equity position if it wasn't part of the plan.
Advanced Assignment Scenarios: Spreads and Pin Risk
Assignment becomes more complex when it involves multi-leg strategies like a bull call spread or a bear put spread.
Pin Risk
Pin risk occurs when the underlying stock price is exactly at or very near the strike price of your short option at expiration. You don't know if you will be assigned or not. If you aren't assigned, you have no position. If you are, you have 100 shares. This uncertainty over the weekend can be devastating if the stock gaps significantly on Monday. The professional advice is always: Close your spreads before the closing bell on expiration Friday if there is any chance of the stock "pinning" your strike.
Exercise by Exception
The SEC and OCC have a rule known as "Exercise by Exception." Any option that is in-the-money by $0.01 or more at expiration is automatically exercised by the OCC on behalf of the buyer. As a seller, you should assume that if your short strike is ITM by even a penny, you will be assigned.
Using Volatility to Your Advantage
High implied volatility often inflates the extrinsic value of an option, which actually decreases the likelihood of early assignment. When IV Rank is high, buyers are less likely to exercise early because they would be throwing away a significant amount of "volatility juice." Conversely, in low-volatility environments, the extrinsic value is thin, making early assignment more probable. Monitoring IV Percentile can help you gauge the market's expectation of price swings and the relative "safety" of your short strikes.
Conclusion
Assignment risk is a fundamental part of options trading. While it can be intimidating, it is a manageable mechanical process. By understanding the incentives of the option holder—specifically regarding dividends and extrinsic value—you can anticipate assignment before it happens.
Always maintain a buffer of buying power, keep a close eye on your at-the-money short positions as expiration approaches, and never hold a spread into the weekend if the stock is near your strike. For more insights on market movements and to track potential risks, check out our options flow and market insights tools.
For further reading on the legal and structural framework of options, visit the CBOE Education Center or Investopedia's Options Guide.
Frequently Asked Questions
What is the difference between exercise and assignment?
Exercise is the choice made by the option buyer to buy or sell the underlying stock at the strike price. Assignment is the fulfillment of that obligation by the option seller, who is chosen randomly by the OCC. Essentially, one person's exercise is another person's assignment.
Can I be assigned on an out-of-the-money option?
While extremely rare, it is possible. A buyer may choose to exercise an OTM option if there is a corporate action or if they have a specific need for the underlying shares that outweighs the financial loss. However, for 99% of traders, assignment only occurs when the option is in-the-money.
How do I know if I have been assigned?
Your broker will typically send you a notification (email or app alert) before the market opens the day after the exercise occurred. You will also see a change in your account holdings, where the short option position disappears and is replaced by long or short shares of the stock.
What is 'Pin Risk' and why is it dangerous?
Pin risk is the uncertainty of being assigned when a stock closes right at your strike price on expiration day. It is dangerous because you won't know your actual stock position until Saturday, leaving you exposed to market moves over the weekend without a way to hedge or exit until Monday morning.
How can I avoid early assignment on my short calls?
The most effective way to avoid early assignment is to close or roll your position before the stock's ex-dividend date. If the extrinsic value of your call is less than the upcoming dividend, the probability of being assigned increases significantly as buyers exercise to capture the dividend payment.