Option assignment

What Is Option Assignment?

Option assignment is the fulfillment of the obligations of an options contract, triggered when the holder of the option decides to exercise their contractual right to buy or sell the underlying asset. This process is a core component of derivatives trading, a category of financial instruments whose value is derived from an underlying asset. When an options holder exercises their right, the Options Clearing Corporation (OCC) assigns a corresponding short option position, obligating the seller (or "writer") of that option to fulfill the terms of the contract²⁸, ²⁹.

For a call option, assignment means the writer must sell the underlying asset at the agreed-upon strike price. For a put option, the writer must buy the underlying asset at the strike price²⁶, ²⁷. The process ensures that for every exercised option, there is a seller obligated to deliver or take delivery of the underlying asset. Option assignment typically results in the conversion of the options contract into shares of the underlying stock²⁵.

History and Origin

The concept of options has roots in ancient times, with philosophical mentions by Aristotle regarding Thales of Miletus using olive press options. However, modern, standardized options trading began with the establishment of the Chicago Board Options Exchange (Cboe) in 1973. Cboe was founded by the Chicago Board of Trade and became the first exchange to list standardized, exchange-traded stock options²⁴. Before this, options were traded in an over-the-counter (OTC) market, which involved direct links between buyers and sellers and more complex terms²³.

The creation of a central clearinghouse, the Options Clearing Corporation (OCC), was a pivotal development that enabled the standardized exercise and assignment process seen today. The OCC acts as the guarantor of options contracts, ensuring that obligations are met even if one party defaults. This significantly reduced counterparty risk and facilitated the growth of the options market, which now includes various asset classes such as equities, indices, and exchange-traded funds (ETFs)²². The OCC's role is to fairly assign exercise notices to clearing members, who then assign them to their clients who have written the corresponding options²⁰, ²¹.

Key Takeaways

• Option assignment is the process by which an options writer is obligated to fulfill the terms of an exercised options contract.
• The Options Clearing Corporation (OCC) manages the assignment process, randomly allocating exercise notices to clearing members.
• For a call option, assignment requires the writer to sell the underlying asset; for a put option, the writer must buy it.
• Assignment typically leads to the conversion of the options contract into shares of the underlying security.
• Options writers should always be prepared for the possibility of assignment, especially if their short options are in-the-money.

Formula and Calculation

Option assignment itself is not a calculation but rather a fulfillment of a contractual obligation. However, the financial outcome for the assigned party depends on the difference between the strike price and the market price of the underlying asset at the time of assignment, factoring in any premium received when the option was initially sold.

For a call option writer:
Loss = ((Market\ Price\ at\ Assignment - Strike\ Price) \times Number\ of\ Shares\ per\ Contract - Premium\ Received)

For a put option writer:
Loss = ((Strike\ Price - Market\ Price\ at\ Assignment) \times Number\ of\ Shares\ per\ Contract - Premium\ Received)

These calculations determine the potential profit or loss for the option writer upon assignment, assuming no other transaction costs or adjustments.

Interpreting the Option Assignment

Interpreting option assignment requires understanding the financial implications for the options writer. When a writer receives an assignment notice, it signifies that the options holder has chosen to exercise their right, typically because the option is in-the-money.

For a call option writer, being assigned means they must deliver the underlying shares at the strike price, regardless of the current market price. If the market price is higher than the strike price, the writer will incur a loss if they do not already own the shares (a "naked call") or a reduced profit if they do (a "covered call").

For a put option writer, assignment means they must purchase the underlying shares at the strike price. If the market price is lower than the strike price, the writer will be forced to buy shares at a price higher than their current market value, resulting in a loss.

The key takeaway for any option writer is that assignment translates a theoretical obligation into a real financial transaction. Therefore, managing short option positions and being aware of potential assignment is critical for options traders. The Options Clearing Corporation (OCC) handles the mechanics of assignment by randomly selecting clearing members, who then use their own methods (such as random selection or first-in, first-out) to assign a specific customer¹⁸, ¹⁹.

Hypothetical Example

Consider an investor, Sarah, who sells one call option contract for XYZ stock with a strike price of $50, expiring in one month. She receives a premium of $2 per share. Each option contract represents 100 shares.

Suppose, at expiration, XYZ stock is trading at $55 per share. The options holder finds it profitable to exercise their right to buy XYZ at $50.

1. Exercise Notice: The options holder notifies their brokerage firm that they wish to exercise the call option.
2. OCC Notification: The brokerage firm sends this exercise notice to the Options Clearing Corporation (OCC).
3. Assignment: The OCC randomly selects a clearing member (and through them, a customer) who has a short XYZ $50 call option, and Sarah's brokerage firm is chosen.
4. Sarah's Obligation: Sarah receives an assignment notice. She is now obligated to sell 100 shares of XYZ stock at the strike price of $50 per share, even though the market price is $55.
5. Financial Outcome:
   • Value of shares sold: 100 shares * $50/share = $5,000
   • Cost of buying shares in the open market (if naked call): 100 shares * $55/share = $5,500
   • Premium received: $2/share * 100 shares = $200
   • Net Loss (if naked call): $5,000 (received) + $200 (premium) - $5,500 (bought) = -$300.
   • If Sarah had owned the shares (covered call), her profit would be the difference between the sale price and her cost basis, plus the premium received, minus the opportunity cost of selling at $50 instead of $55.

This example illustrates how option assignment directly impacts the writer's position, leading to either a mandated sale or purchase of the underlying asset.

Practical Applications

Option assignment is a fundamental event in options trading, with several practical applications and implications across various financial activities.

• Risk Management: For option writers, understanding the mechanics of option assignment is crucial for risk management. Uncovered or "naked" options positions carry substantial risk of significant losses upon assignment, as the writer may have to buy or sell the underlying asset at unfavorable market prices¹⁷. Regulatory bodies like FINRA emphasize the importance of appropriate account approvals and supervision for options trading due to these inherent risks¹⁵, ¹⁶.
• Arbitrage Opportunities: While less common for retail traders, the potential for assignment can sometimes be a factor in professional arbitrage strategies where discrepancies between option prices and underlying asset prices are exploited.
• Corporate Actions: Corporate actions, such as dividend payments, can influence whether an option holder decides to exercise early, which in turn affects the likelihood of assignment for the writer. Call options may be exercised early by holders to capture an upcoming dividend¹⁴.
• Regulatory Reporting: Financial regulatory authorities, such as FINRA, require firms to report certain details about options transactions, including when an option is exercised and assigned. This data helps in market surveillance and ensuring fair trading practices¹³. The Federal Reserve Bank of St. Louis offers educational resources, like its "Economic Lowdown" podcast series, which can help explain complex financial concepts related to markets and trading.¹¹, ¹²

Limitations and Criticisms

While option assignment is a necessary part of the options market, it comes with certain limitations and criticisms, primarily from the perspective of the options writer.

• Unpredictability: While assignment is highly likely for in-the-money options at expiration, it can sometimes occur unexpectedly for options that are at-the-money or even slightly out-of-the-money, particularly for American-style options which can be exercised at any time before expiration¹⁰. This unpredictability can make position management challenging for writers who aim to avoid assignment.
• Forced Transaction: The most significant criticism from a writer's standpoint is the forced nature of the transaction. Once assigned, the writer has no choice but to fulfill the obligation, which might involve buying or selling shares at a loss or at a price that is less advantageous than the current market rate⁹. This can lead to unexpected capital requirements or sudden changes in portfolio composition.
• Early Assignment Risk: For American-style options, the risk of early assignment exists, meaning the writer could be assigned before the expiration date. This often occurs when a call option is deep in-the-money and a dividend payment on the underlying stock is imminent, as the holder might exercise to receive the dividend⁸. This can disrupt a writer's strategy and introduce unforeseen obligations.
• Complexity for New Traders: The mechanics of option assignment, coupled with the potential for margin calls if the assigned position requires significant capital, can be complex and overwhelming for new options traders. Regulators like FINRA frequently issue notices and guidelines to brokerage firms emphasizing the importance of proper due diligence and supervision for customers engaging in options trading⁶, ⁷.

Option Assignment vs. Option Exercise

Option assignment and option exercise are two closely related yet distinct concepts in options trading. The fundamental difference lies in which party initiates the action and which party is obligated to respond.

In essence, option exercise is the action taken by the options holder, while option assignment is the consequence for the options writer resulting from that exercise. One cannot occur without the other in a successful options trade.

FAQs

What happens when an option is assigned?

When an option is assigned, the seller (writer) of the option is obligated to fulfill the terms of the contract. For a call option, the writer must sell the underlying asset at the strike price. For a put option, the writer must buy the underlying asset at the strike price. This typically results in the conversion of the options contract into shares of the underlying stock.

Is option assignment automatic?

The decision to exercise an American-style option is typically made by the holder, who then notifies their brokerage. European-style options are automatically exercised if they are in-the-money at expiration. Once an exercise notice is submitted to the Options Clearing Corporation (OCC), the OCC's assignment process to a clearing member is random, and the clearing member then assigns one of their short option customers, often using a random or first-in, first-out method⁴, ⁵. So, while the initial exercise may or may not be automatic depending on the option style, the assignment to a specific writer is part of an automated or standardized process orchestrated by the OCC.

Can I avoid option assignment?

Options writers can try to avoid assignment by closing out their short option positions before they are assigned. This involves buying back the option contract in the market, which cancels their obligation. If a short option position is in-the-money as expiration approaches, or if there's a significant dividend event for a call option, the likelihood of assignment increases, and closing the position out may be the only way to avoid it³.

What is the role of the Options Clearing Corporation (OCC) in assignment?

The Options Clearing Corporation (OCC) plays a crucial role as the central clearinghouse for options transactions. When an option holder exercises their right, their brokerage firm notifies the OCC. The OCC then randomly assigns the exercise notice to a clearing member firm that has a customer with a corresponding short option position. The clearing member then assigns the obligation to one of their specific customers who wrote that option¹, ². The OCC acts as the guarantor, ensuring that all assigned obligations are fulfilled.

Does option assignment always mean a loss for the writer?

Not necessarily. While assignment often occurs when an option is in-the-money, leading to a loss or reduced profit for the writer compared to the current market price, the overall profitability depends on the premium initially received and the original cost basis of any underlying shares involved. If the premium received was substantial enough to offset the difference between the strike price and the market price at assignment, the writer could still realize a net profit. However, without sufficient premium or if the price moves significantly against the writer, assignment can lead to substantial losses.