For the beginning options trader, there is a potentially confusing new vocabulary with which he needs to become familiar. These terms are necessary to use and understand because there are more “moving parts” to be encountered when dealing withoptions.
One such potentially confusing area is that of option exercise and option assignment. These two concepts are not interchangeable and represent the two sides of a transaction initiated by the holder of the long option. The purchaser of an option has only rights; he has no obligations, and may buy or sell stock at the strike price by exercising the call or put. The seller of an option has no rights, only obligations, and may be required by option assignment to sell or buy a stock atthe strike price. An easy way to remember this is that option exercise is an active process triggered by the option holder while option assignment is the offsetting transaction required of the option seller.
The trader who buys a call option has the right to purchase the underlying issue at the strike price from any time from the purchase to expiration by exercising the option. Similarly, the trader who buys a put option mayexercise and sell the underlying at the strike price at any time until expiration. These traders, having only bought options, haveno obligations. The process of option exercise can be initiated either by a request to the broker or, more frequently, by “automatic exercise” at expiration by the broker who can be relied on to exercise options containing any intrinsic value.
One detail of which the trader should be aware is that of the existence of two categories of options which differ in their ability to be exercised. American style options, the category usually encountered, can be exercised at any time during their life. European style options, found as some index options, can only be exercised at expiration.
The trader who sells a call option has the obligation to deliver stock at the strike price on request at or any time prior to expiration. When short options are held aspart or all of a given position, the trader needs to assess his risk of being assigned before expiration. This risk is known as early assignment. Generally, such early assignment risk only applies to options which are in-the-money. This risk of assignment can be logically considered by putting yourself in the shoes of the option holder. The option holder can be expected to make a rational decision based on his economic best interest. His choices to close a position are either to exercise the option or simply to sell it.
Remember that option premium, while quoted as a single price, is really the sum of both intrinsic premium (if any; not all options have intrinsic value, as for example, out-of-the-money options which consist entirely of time value) and extrinsic (time) premium. As the owner of an option, exercise will capture only the intrinsic value. By selling the option in the open market, both the intrinsic and extrinsic values can be captured.
Consider the following examples:
1. You have a long position in AAPL stock against which you have been selling covered calls. You are currently short December 310 calls; the stock is trading at 315 and the options are priced at $11.65. A quick calculation indicates there is $5 of intrinsic value and $6.65 of extrinsic (time) value embedded in the premium. The risk of early assignment given this situation is zero. The holder of the option would be far better off selling the option and capturing both intrinsic and extrinsic values.
2. You have a long position in CAT against which you have sold covered calls. The stock currently trades at $84.13,and you are short the December 70 calls which trade at $14.15. A similar calculation reveals there is$14.13 of intrinsic premium and 2¢ of extrinsic (time premium). The risk of being assigned these calls and having to deliver CAT stock is substantial.
A special case where the risk of early assignment is high is that of being short calls when there is an impending dividend. If the time value of the option is less than the dividend to be declared, early assignment is an almost certainty. This is because the owner of the call wants to buy stock so that he is entitled to receive the dividend. It is particularly important that the covered call seller beaware of this high risk of assignment should he be short calls in excess of the stock he owns because he would then be a short seller and required to pay the dividend to the stock purchaser.
Issues of assignment and exercise are one of the concepts with which the option trader must be familiar. While these actions are no problem when properly anticipated, they can represent an unexpected turn of events to the unprepared trader.