Question
I don’t know if I am even directing this question properly, but I am trying to overcome the bs replies from various brokers and the option trade groups. How is it possible or justified that a call writer who is assigned on a Thursday or Friday is not be informed of it until it is too late to do anything other than buy shares in the open market to deliver, incurring a heavy loss? It seems to me this should be fought vigorously. Especially with spread positions the writer needs notice of the short leg assignment in time to exercise his long leg in order to acquire the shares at the strike price. Notice to exercise and notice of assignment should be required to be delivered by Friday morning and no later. Am I missing something here, except the advisability to always close out spread positions before expiration?
Answer
This is a very complex topic to address because there are so many moving parts to option assignment. I will try to break my response down into a number of different areas.
First of all, let’s be clear. We are talking about assignment on a stock option. Cash settled American-style options like the OEX is a completely different story and I’m not going to cover those complexities in this article.
When you sell options (covered or uncovered) you have obligations, no rights. Before you consider selling an option, get used to the idea that you are powerless. You do not control the situation, the option buyer does.
The naked call writer has unlimited risk. If the stock skyrockets, eventually the writer will lose point for point with every dollar the stock rallies. The option short seller will never get assigned unless the option is in the money. It must have intrinsic value and the option must not be trading with any time premium. If the option is carrying premium above its intrinsic value, the option buyer will be better off selling the call in the open market than he will be exercising the call. If you don’t understand this statement you need to brush up on your option basics.
Let’s say that the option is trading at its intrinsic value. As the naked writer, you must know that you are at risk. If you want to avoid assignment, you need to buy your call in. As far as risk is concerned, you don’t have any greater risk by being short the option or by being short the stock via assignment. At this stage, every point that the stock moves higher, the options will increase in value by that same amount and so will your liability. The delta of the position is -1 and you are effectively short the stock by being short the option.
In the case of a call credit spread, your risk is limited to the difference in the strike prices less the credit received. Let’s say that you sold the $50 calls and you purchased the $55 calls. The stock rallies and it is that $56 a few days before expiration. If you get assigned on the $50 calls, you are short the stock at $50. You can immediately exercise your right to purchase the stock at $55. The end result is that you are selling the stock at $50 and buying it at $55. You still get to keep the credit he received, so your risk profile has not changed due to assignment. You have simply lost the maximum on this trade. This same scenario will hold true no matter how high the stock goes. It could go to $100 and your outcome would be the same.
Let’s say that you were assigned and you came in the next day and the stock dropped from $56 to $54 on the open. If you are contesting that because of assignment you now lost money on your $55 call that you are long, you would be wrong. The $55 call will lose value, but it has a lower delta then the stock. Let’s use some real numbers. When you were assigned on the stock it was at $56. You were short at $50. When you come in the next day you are able to buy this stock and cover the position at $54, $2 less than it closed the day before. In this case you only lost $4 (not $5), plus you still own the $55 calls. Clearly, in this case getting assigned actually helped you.
As you can see, getting assigned on one of the legs of your spread did not increase your position risk, it could only reduce it. The maximum risk on a stock credit spread is the difference between the strike prices, plus the credit received.
Briefly, if you are in the spread on expiration Friday and one of the legs is closing right at the money and you don’t know if you are going to get assigned or auto exercised, close the spread. Otherwise, you might come in Monday morning with an unexpected position and that could increase your risk. This was not a primary topic for this article, but I thought I would make reference to the situation.
To this point I have talked about how assignment on a naked short or a credit spread does not impact the risk profile of the position. Now let’s talk about the assignment process and what a good brokerage firm should do to help you.
Option buyers have until the close to hand in their exercise notices. The brokerage firms submit the exercise request to the Options Clearing Corporation (OCC). The OCC processes the request and uses a lottery system to determine which brokerage firms that have a short position will get assigned on the option. They also determine how many contracts the firm will be assigned on. Overnight, the OCC notifies the brokerage firm and they need to review all other accounts that are short those options. Through a standardized lottery system they determine which customers will be assigned. As you can see the processes involved.
Once the brokerage firm allocates its assignment across the accounts, it should notify customers that this has taken place. That notification can take any form. I’m certain that in the age of electronics, brokerage firms put the responsibility on the customer to check the account on a daily basis.
As a customer, if you are assigned you will look in your account and see that you are short shares of stock if you were short calls. Once the market opens you can either exercise the same number of calls or you can buy the shares as I described above.
During assignment, you have one day to adjust your position (the next business day) without incurring the additional margin required for a short stock position. If you cover the position that day you are granted something called “same-day substitution” and you are not required to put up any additional margin.
As you can see, the assignment process is complex. Where stock options are concerned, the assignment does not increase risk, it can only reduce it in the case of a spread. It would be nice if a brokerage firm notified you as soon as they are allocating assignments, but I know that is not always the case.
