Assignment risk management

In short

A friend of mine sold a covered call on a Monday and forgot about it by Wednesday. On Friday morning her shares were gone, called away at the strike price. You have probably sold an option, or you are thinking about it, and you would like to avoid that kind of surprise. Assignment happens when the buyer of your option exercises it, and your side of the deal comes due. It can happen at any time before expiration if the option is American style, which covers most stock options. Early assignment is not common, but it is far from impossible. The risk goes up when an option is deep in the money, when a dividend is near, or when little time value is left. Know your exposure, keep cash or shares ready, and read what your broker sends you. Steady habits beat clever tricks here.

The whole of it

What it is

I once watched an old farmer sign a contract to sell his corn in the fall at a set price. When the day came, the price had jumped, and he still had to deliver at the old number. He did not complain. He had made a promise, and a promise is a promise. Assignment works the same way.

When you sell an option, you take money today in exchange for a promise. If you sold a call, you promised to sell 100 shares at the strike price. If you sold a put, you promised to buy 100 shares at the strike price. Assignment is the moment someone holding the other side says, "I would like to use my right." The Options Clearing Corporation, which stands behind listed options in the United States, picks a broker at random. Your broker then picks a customer, and sometimes that customer is you.

Assignment risk is just the chance of that happening at a time you did not plan for. It is not a fee and not a penalty. It is the deal you made, arriving early.

How it works

If you have sold an option, you are on the receiving end of a choice you do not control. The buyer decides when to use it. You decide only whether you can handle it.

Picture a call you sold. If the stock sits well above the strike, the buyer has two ways to profit. They can sell the option, or they can use it and take the shares. Using it early gives up whatever time value remains. So many buyers hold on or sell. But some do use it early, and a few things make that more likely.

The first is a dividend. If you hold a short call and the stock is about to go ex dividend, the buyer may use the call the day before to collect the dividend. If the dividend is bigger than the time value left in the option, early use can make sense for them. The second is a deep in the money option with almost no time value. The buyer loses little by using it. The third is a put that is far in the money, where the buyer would rather have the cash now than wait.

After assignment, things happen fast. If you were assigned on a call and you do not own the shares, your account is suddenly short stock. That can trigger a margin call, which is a demand from your broker for more cash. If you are assigned on a put, you take on the duty to pay for 100 shares at the strike. If the cash is not there, your broker may sell something to cover it, and you may not like what they choose.

Notice that you are told after the fact. Assignment is often posted overnight, so you may learn the next morning. Check your account each day while you hold short options.

The numbers, and where to find yours

You do not need many numbers to manage this well, but you need the right ones. The ones set by the exchanges are few. A standard equity option covers 100 shares, and your broker's options agreement spells out the margin it requires. The Options Clearing Corporation publishes the rules on exercise and assignment, and the document called Characteristics and Risks of Standardized Options is the plain reading every options account holder is given. You can find it on the OCC website, and your broker must hand it to you before you trade.

The numbers that are yours alone live in your own account. Look for your strike price, your expiration date, the stock's ex dividend date, and the amount of the next dividend. The ex dividend date and dividend amount are posted by the company and shown on most quote pages. Look also at the option's time value, which is the option price minus how far it is in the money. A small time value next to a big dividend is the warning light.

Then look at your cash and buying power. Buying power is the amount your broker lets you spend. Ask whether you could pay for assigned shares today. If the answer is no, you are carrying more risk than you think.

A worked example

Consider a man named Walter, who is sixty one and owns 300 shares of a stock. The stock trades at 50 dollars. Walter likes the stock but would not mind selling at 55, so he sells three covered calls with a 55 dollar strike. He takes in 1.20 dollars per share. That is 1.20 times 300 shares, or 360 dollars before fees.

Weeks pass, and the stock climbs to 60 dollars. Walter's calls are now 5 dollars in the money, since 60 minus 55 is 5. The calls trade at 5.10 dollars. The time value is 5.10 minus 5.00, which is 0.10 dollars. That is very little.

Now the stock is about to go ex dividend, and the dividend is 0.40 dollars per share. The dividend, 0.40, is bigger than the time value, 0.10. A buyer of those calls may well use them tomorrow to grab the dividend. Walter sees this and knows he has choices that are his to make.

If he does nothing and is assigned, he sells 300 shares at 55 dollars. That is 55 times 300, or 16,500 dollars. Add the 360 dollars he collected, and his total is 16,860 dollars. He gives up the move from 55 to 60, which is 5 dollars times 300 shares, or 1,500 dollars. He also gives up the dividend.

If he wants to keep the shares, he can buy back the calls at 5.10 dollars. That costs 5.10 times 300, or 1,530 dollars. He took in 360, so the net cost of closing is 1,530 minus 360, or 1,170 dollars. That is a real loss, but it keeps his shares and his dividend. He could also roll the calls out to a later date and higher strike, though that has its own cost.

Neither path is right for everyone. Walter picks the one that fits his own plan, because he looked before the ex dividend date and not after.

Where it goes wrong

Trouble often comes from looking away. A person sells an option, sees the premium land, and stops paying attention. That is human. But a short option is a promise with a clock on it.

Another trap is holding a short option through an ex dividend date without checking. The loss is small on paper, yet it stings, because it was avoidable. A third is the spread. Someone sells one call and buys another to limit the risk, then gets assigned on only the short leg. For a time they hold a stock position they never planned on. Their long call still protects them, but they must act, and quickly.

Then there is the cash problem. A put seller who cannot afford the shares may face a forced sale at a bad hour. And a call seller without shares may find a short stock position and a margin call in the morning.

Last, do not treat assignment as a failure. It is a normal result of the contract. Plenty of careful people are assigned and are glad of it. The mistake is being unready, not being assigned.

Questions to answer before you leave this page

Do you know the expiration date and strike price of every option you have sold? Could you pay for the shares today if a put were assigned, or deliver the shares if a call were? When is the next ex dividend date for the stock behind your option, and how big is the dividend? How much time value is left, and is it smaller than the dividend? Have you read the Characteristics and Risks of Standardized Options document from the Options Clearing Corporation? Does your broker's options agreement say how and when it will tell you about an assignment? And if you woke up tomorrow assigned, would you feel ready or ambushed?