The purchaser of an option can exercise their right at any time during the life of an option. Exercising is simply enforcing your right to purchase or sell the underlying asset. During my entire life as an options trader I have only been exercized early once. Assignment and exercising of options is nothing to be afraid of as long as you know the mechanics of assignment. In the event that an option is exercised, the writer of the option has an obligation to fulfill the terms of the option.
So the mechanics of assignment is simple due to the governing body of options called the Options Clearing Corporation (OCC). The OCC is the issuer of all listed options contracts, thus it controls all listed option assignments and exercises.
So how do you exercise your option? – simple, you instruct your broker to do so. Your broker will notify the OCC that they wish to exercise a contract of the underlying stock. Now the OCC springs into action and selects “AT RANDOM” a holder of the contract who is SHORT that contract (meaning they have sold that contract) and then the OCC will notify that person that they have been Assigned.
So the selection of the person being assigned is really quite simple:
- random selection
- First in/first out basis
- any other systematic selection criteria that the OCC deems fair
Now that you have been assigned
You must deliver the stock… and… you have no choice in the matter. Now it is too late in the piece to try buying the option back, and if you’re short naked (meaning you have no covering position) then your situation might look quite bleak indeed. However, all is not so bad as you have a couple of choices as to how you go about fulfilling your obligation to deliver the nominated number of underlying contracts. you can;
- deliver the stock from your own reserves (assuming you own the stock)
- purchase the stock in the open market to deliver them to the assignor
- ask your brokerage to go short and deliver the stock (this requires you to have a short account with your brokarage firm… most brokerage firms do not let nocive traders short sell, and require a minimum account value of a few hundred thousand dollars.
Margin Calls
Sometimes during assignment the process of purchasing the stock to cover your position and fulfill your obligation might result in a margin call. A margin call is where you have insufficient funds to cover your position. This is not relevant so much today as most brokerages (all that I know of anyway) only require you to have the marginal difference between the exercise price of an option and the price of the option itself.
When can you be Assigned?
Assignment can take at anytime throughout the duration of the options contract. Generally speaking, if you are the seller of the option and the option goes into the money you always run the risk of early assignment. This is called early or premature assignment. Otherwise, options are always certainly exercized if they are in the money at expiration. Assignment is generally something you’d normally avoid, so it is always advisable to cover your postion by buying back the inthe money option before or on expiration day.
The option reason for early asignment could be due to an impending dividend payout. Generally the stock price will go down by the value of the dividend payout and so exercise can occur so that the position of the holder of an option is not diluted due to the divend. By exercising their rights and taking hold of the stock they effectievly have a net $0 postion by taking the dividend payment. Quite obsucre is this situation, but it does happen.