Options Trading: Options Exercise and Assignments

UNDERSTANDING OPTIONS TRADING

Episode 06 – Exercise & Assignments

David McGann (00:17):

Hello to all of our viewers. My name is David McGann. I'm a director here at BMO Investor Line, and I'm thrilled to be co-hosting today's webinar on options, exercise, and assignments. This comes to you as part of our webinar series that seeks to unpack options trading. Be sure to check out our education hub to find other webinars in the series that may be of interest to you. Once again today we'll be joined by our friends at Options Play, and I'm pleased to introduce Jessica Inskip. Jessica is a director of education, and product at Options Play, where she focuses on bridging the gap between education, and complex financial products. Her work is featured in esteem firms, and exchanges, including Fidelity, Merrill, TD, and NASDAQ. She's held diverse roles in brokerage firms, including specializing in high frequency trading, complex options, and derivative strategies. We're pleased to have Jessica back here with us today to go through some great content on options, exercise, and assignments. And with that, Jessica hand things over to you.

Jessica Inskip (01:11):

And thank you so much, and absolutely a pleasure to be here. It's so important to talk about the complexities that is options, especially exercise, and assignment can be an interesting topic. So, happy to dive in today. So, first, and foremost know that options can be complex, and that's because not only does it derive from an underlying security, but we add this layer of complexity, which is time, and implied volatility, which affects the price of an option. And because it contains the right to buy, or sell, there is this component of exercise, and assignment that can lead to heightened attention. It requires position management, but that position management starts with understanding concepts, and how they work. That being today's exercise, and assignment. So, we understand the exercise, and assignment process, then that helps us understand the type of strategies that we're deploying, and what happens in those type of events, if you will.

(02:12):

So, nonetheless, before we dive in, it's important to talk about some disclaimers. Like I said before, options are complex. They're not necessarily for everyone, which means that there is certainly a lot to learn. There are lots of disclosures that you would see. Any information that we are using today is purely for informational, and educational purposes only. Options Play, of course, is that third party bringing on today that we're discussing. So, before we dive in, we need to talk about what we're going to focus on today if you will. First, and foremost, let's talk about what an option is. Whenever we're dealing with exercise, and assignment, it really depends on the type of option that you have that determines if you have the right to exercise, and, or the obligation that leads to the subsequent assignment. So, we have to do those foundational basics, and the anatomy of an option in order to understand how that affects us as options traders, or options holders.

(03:12):

That leads to understanding the options pricing components. When we're selling an option versus buying an option really goes to those foundational elements of understanding how an option is priced. If we understand how an option is priced, it leads to understanding our likelihood of being assigned, or if it makes sense for us to exercise, or not. Topics that we will, and definitions we will definitely dive deeper into today to understand more on. Then we've got different types of options. There's something called an American option versus a European option, which just goes through the styles which we need to understand because that affects exercise, and assignment differently. We'll talk about then the process, some key statistics that you may not know, or you may know as far as how many options are actually assigned, or exercised, or even expired worthless, which may be your goal. And we'll talk about what happens the day of expiration when you hold an option, a long option, that means you're an option buyer, and what happens where an option seller.

(04:14):

And there are some items that are in your control, and others that are out of your control, but if we understand our surroundings, then we can understand the impact of those surroundings, and therefore that helps us make those better decisions. And of course we'll talk about some risks, and some of those out of box one-off circumstances that's important for you to be aware of before they happen rather than after. So, bringing up those risks certainly helps lay that foundational element to understand the complexities that are options. So, let's go ahead, and dive in. And of course keep this question in mind. I know that was a large agenda, but what we want to focus on today is how does the options exercise, and assignment process impact me? Because you are the options holder. In this case, did you buy, or sell? Perhaps there's even a multi-leg strategy, a covered call. How does that affect you? That's really the goal of today is to understand that to help you make more informed trading decisions.

(05:12):

So, let's start with the basics. What is an option? An option is simply a contract between a buyer, and a seller. When you are purchasing an option, your goal is for that option to go up in value as much as possible, and that's because the options purchaser, the options buyer. Another word for that is a long option. You own the execution rights, you own the right to buy, or sell the security, and the seller is obligated to fulfill the other side of that. So, what does that exactly mean? If it sounds like a lot of legal jargon, that's because it is essentially a contract, and it's decided if it's a call put, or excuse me, that option is issued as a call, or a put, which is going to give you the indication if it contains the right to buy, or if it contains the right to sell. So, in this example that we see on the screen, you have a buyer that is giving the premium to the seller. The buyer is the one that is paying for that option contract.

(06:10):

They're paying the value, therefore they are buying the right to execute upon the terms of that contract. The sellers receiving that upfront payment, we call that an upfront credit, and they're obligated to fulfill the terms. So, in this example, you see 100 shares of ABC with 100 dollars per share, and it has an expiration date attached to it. That means if this were a put, the buyer of this option would pay a premium for the right to buy 100 shares of ABC at 100 dollars per share at any time through the expiration period. If it was a put, the buyer would have the right to sell, and then the obligation someone has to buy, or sell those securities be on the other side that falls on the contract writer we call it. That's why it's called a contract writer. They are the seller of the contract. They're obligated to fulfill the terms that they agreed upon. So, those are the basics.

(07:01):

When we are thinking about options, and we're going to shift this, if you've attended any of the previous sessions, or looked at BMOs course, we tend to think of options as drivers, and sellers. So, I want you to keep your mind around that as we go through today's presentation. When we're buying an option, you are in the driver's seat. You are the one who owns the execution rights. You decide if you can go left, or right, whereas if you are an option seller, you're on the passenger seat, you are obligated to go left, or right at the buyer's discretion, but we can pay attention to our surroundings. And paying attention to your surroundings is really understanding, and that leads to anatomy of an option, and how an option is priced. So, in this example, when we have an option contract, there are some questions that we ask which is what quantity are we agreeing on? What product, what price, and what timeframe? This is all jargon for just really what comprises an options contract. The quantity is the contract amount. One contract generally represents 100 shares.

(08:02):

So, if you see one contract, think 100 shares in your mind. Do I have the right to buy, or sell 100 shares? We're always looking at it at the lens of the person in the driver's seat, what product that's the underlying security can be a stock ETF, exchange, fund index, currency, a commodity, in this example we're just utilizing ABC. So, this contract represents 100 shares of ABC. The price, that's another word for strike price. That's price per share. That's the price that it's agreed to buy, or sell. So, in this example, $100 per share, and then the timeframe, that's your expiration normally on Fridays. But as of late, as more products are being issued, you can find options expiring almost every single day. But that's the complexity that's added to options. Not only is it derived from the underlying security like ABC here, but there's only a timeframe that this contract will exist, and once that timeframe passes, the contract ceases to exist.

(09:01):

So, knowing that time component is very important, and that is called the premium. So, the option is issued, I said before as a call, or a put a call is going to contain the right to buy, a put, the right to sell. The option can be exercised. And remember if you're in the driver's seat, or you purchase the option, you are the one who owns those execution rights. You do that on your terms can expire, which may be your goal like the term of a short option holder. They don't want the option to go up in value. They really just want it to deplete in value, which could happen with time decay, or price movement, hence those complexities we have to understand. Or it can be traded, which is then traded for a price known as the premium. And the premium is what that option, or at least what the market believes that option is worth. And that premium is comprised of two components. We've got intrinsic value, and we've got extrinsic value. I've got a little trick for you just to keep that in your mind as we go through this quick review.

(10:07):

Intrinsic value is really the internal factors that affect the option. So, in the case of a call, remember a call contains the right to buy a specific amount of shares within a specified timeframe. In our previous example, it was 100 shares of ABC at $100 per share. So, if I have the right to buy ABC at $100 per share, it has executable value if it's also called in the money, if it has a more favorable price than the market. So, for example, I have the right to buy at ABC at 100. If ABC is at 110 per share, well that contract has to be worth at least $10 per share, because I can take the terms of that contract, buy 100 shares of ABC at $100 per share, take ownership of those shares, and then immediately sell it at the market for 110. So, that's $10 of executable, intrinsic, or in the money value. Again, those are synonymous terms, but it's important to know that a contract, an option contract cannot have any in the money, or executable value.

(11:05):

It really is determined by price, which is the internal factor that affects the options premium. The external factors is also known, excuse me, also known as extrinsic value. So, the external factors also known as extrinsic value is comprised of time value, and implied volatility. Think about the logic behind that. The more time the option has until expiration, the more expensive it's going to be, because the more likelihood, or the more time it has to get that executable value. And implied volatility, that is really events that could inflate the options premium. So, extrinsic value inflates, or deflates really based on the likelihood of it having executable value. So, those are external factors where you can find a lot of resources on how to understand the effect of an options premium, but from the premium perspective that you need to know an understanding exercise, and assignment like that example we had before bringing it into real terms, we have ABC stock at 103 per share, and we still have that same ABC 100 strike call with 30 days till expiration, and it's trading at $5.00 Per share.

(12:21):

Well that means there's in the money value of at least $3.00 Per share because again, I own the rights to buy ABC at $100 per share, the market is pricing it at 103. That means that I can make at least $3.00, 300 total because one contract represents 100 shares, but that options price is $5.00 per share. So, the excess is what becomes the extrinsic value, and that extrinsic value is those external factors that are constantly inflating, and deflating, and that time value component is always moving against us. So, therefore it's something to consider when it makes sense to exercise, or the likelihood of assignment really matters to understand how an option is priced. And we'll dive a lot deeper into that as we have some examples. But in order to understand that which is a very frequently asked questions, will my option be assigned, or should I exercise? It's imperative to understand how an option is priced. Now, if that seemed like a lot, because that was a very quick review, we have a little trick for you that we like to utilize.

(13:32):

This is called a T chart, and you may, or may not have seen this before. The intent of this is because options can be complex, they are essentially a mirror. If you focus on long calls, which we're going to use in a lot of the examples today, you can come back to this T chart, and figure everything, excuse me, figure everything else out for lack of a better word there. The way that this is comprised, we have calls on the left-hand side, and we have puts on the right-hand side, and what you'll notice is long calls are going to be on the upper left-hand quadrant, and then we've got short calls below that. Short puts, we're going to switch it up here, are going to be on the upper right-hand quadrant, and then long puts below that. And what this does is it puts bullish strategies on the top, and bearish strategies on the bottom. And what's important to keep in mind here because now we're shifting to understanding exercise, and assignment, and know that this is all based off of option strategies is the practical application of it all.

(14:31):

When you're deploying these strategies individually, there is a goal associated with it because it's derived from an underlying security. So, you perhaps have a sentiment on that underlying security, but then you also understand those external impacts. So, the takeaway that you just keep in your mind as you're looking at this, when I purchase options, I own the execution rights. I expect a sharp directional movement, because I want that option to go up in value as much as possible, but I paid a premium for that option, and that's something that could work against me, because that premium has an extrinsic value component which is time value, which is a decaying factor. Whereas on the flip side, if I'm selling an option, those short puts are directional, yes, bearish, and bullish. So, bullish for short put, and bearish for a short call, but they are neutral with a slight directional bias because those contracts individually realize their maximum profit potential when they decay in value. So, the inverse, a long option holder is in the driver's seat.

(15:37):

They want the option to have as much value as possible, and they own the execution rights, whereas the short option holder is in the passenger seat, and they're looking for that option to deplete in value. So, the long option holder, and the driver exercises short option assignment, keep that in mind, and of course we'll give you some intricacies, and make sure you understand that all the way through. Now, if that wasn't complex enough, let's introduce a new term which is American versus European styles. You're probably very familiar with American style options. That's equity options. That means that they are physically settled. What does that mean? Well, we've had some examples of ABC stock before I can take ownership of ABC stock. It's traded on the secondary market so I can go ahead, and buy that stock. So, that's what we mean by physically settled. Those can be exercised at any time, because I own those execution rates, whereas a European style option, think about an indices, or an index, you can't purchase an index directly, you can only purchase a product that mirrors that index like an ETF.

(16:50):

So, for example, you can't go buy the S&P 500, or SPX, but you could buy SPY, S-P-Y, SPY, that ETF that mirrors the S&P 500 is an American style option, because I can physically own the ETF. Whereas options which can have a product derived from an indices like the S&P 500, that's a European style option, which it's cash settled. So, the difference of in the money value at the day of expiration is what's decided. So, breaking that out a little more, I've got an example for you here. If we've got a long equity call, and a long index call, the long equity call is going to be American style. The long index call is going to be European style in this case. If we have a SPY call that is $430 a share at $10, and SPY is at 440, well this is a call. I can buy SPY at 430 immediately sell it the market at 440, that $10 that's in the money value, this is worth $1,000 total. And if this was the day of expiration, remember on the day of expiration, an option is normally worth only its intrinsic value.

(18:02):

So, we would expect that extrinsic value to deplete that can change rapidly of course on that day of expiration, but generally that's what occurs. So, I would be able to, generally, close this out for $10 per share, whereas a long index call, so the underlying now that's what we're changing, is the indices, not the ETF that mirrors the indices. If we have a call that's at 4,400, and SPX is at 4410, which is definitely far away from right now, that's $10 per share of intrinsic value. So, the same here applies, and that multiplier equals a dollar amount. So, $10 times 100 dollars, that's the multiplying factor that's there. We'd be credited a thousand dollars to the account. So, the monetary value is essentially the same, but what's different is the underlying product. And since there's a different underlying product, we have different styles of options which is American, and European. So, one is going to be settled in cash, and the other would switch ownership of the underlying security. In this case it's the exchange traded fund.

(19:13):

Now, there are different items, and nuances that go into index options, but what I want you to take away from this is the exercise style because that's what we're focusing on today is understanding exercise, and assignment. This does vary, but generally, equity options, American style options, you can exercise at any time. Since they can be exercised at any time, so back to the driver, and the passenger, that means there's assignment risk at any time, because there's an obligation associated with it. When we're trading index options, or those European style options, you remove assignment risk except for the day of expiration, because they can only be exercised on one day, which is the day that they expire. Otherwise, they're traded on the secondary market, both of which are traded on the secondary market. So, that's the importance item to take away from this is how does the exercise, and assignment process affect the different types of products? And that's why we'll focus on index options today. I know we have another webinar, and other material that you can definitely dive deeper into.

(20:17):

So, let's focus on the assignment process. There's so many questions, and understandings of how does this actually occur, and oftentimes this question comes up the first time you're surprise assigned, meaning not on the day of expiration. So, going back to the equity options, or American style options, and that's because there's someone sitting in the driver's seat, and that's a long option holder. So, in order to exercise an option, the long option holder going to have to contact their brokerage firm. Their brokerage firm is then going to take those instructions, could be online, or calling directly, and send that to the clearing firm. The clearing firm is then going to have to find somebody who is short that option an offsetting seller, and they're then going to go randomly assign another brokerage firm, could be the same brokerage firm that that long option holder was at, could be a completely different one.

(21:13):

And then once that brokerage firm receives those assignment instructions, they're going to take their short options holders either randomly, or first, and first out that's determined on the brokerage firm, and then that's the person who is assigned. So, it's exercise, and then subsequent, excuse me, exercise, and then subsequent assignments. But it's a longer process than most realize. And what is important to know here is the long option holder does not know the strategy on the other end. They do not know that you have a covered call, and your shares are going to be called away. All that they know is they own a contract that gives them the right to buy. You sold a call in that example of a covered call, but you're obligated to sell them those shares when they want to execute upon that. And that's a process that could catch you by surprise, but you have to pay attention to your surroundings, and understand the premium in order to understand if you will be assigned, or not.

David McGann (22:10):

Jessica, can I jump in?

Jessica Inskip (22:12):

Sure.

David McGann (22:12):

First of all, great recap on just some of the foundational fundamentals of options, and how they work. Super important, obviously, for this topic in terms of exercise, and assignments. And so assuming I sold an out of the money option with 30 days to expire, which later becomes in the money before expiry, what is the likelihood of my option being assigned since the regulator's assigned a broker at random? Are there any insights on criteria for who gets assigned, and how can you expand on that a bit?

Jessica Inskip (22:44):

Yeah, absolutely. And I think it's great to bring in a real example to that question, so thank you for that question. If you've got an option that was out of the money initially, so like that covered call example, and then it moves in the money, or maybe it doesn't even, it's all about paying attention to your surroundings, and you have to look at it through the lens of the long option holder. Does it make sense for that long option holder monetarily to exercise those contracts? Which goes back to understanding the extrinsic value. When you are exercising your option contract, the question that your brokerage firm normally asks you, or that offsetting position would be, are you giving up any extrinsic value? And if you are giving up any extrinsic value, probably not a wise decision to execute upon the terms of that contract. And there may be reasons, too, which we're going to discuss in a moment, but that's what you would pay attention to, is if I was in the driver's seat, and there is a red, or a stop sign ahead, are they going to stop?

(23:48):

But you need to know that there's something ahead, and that's something ahead is is there extrinsic value left pricing into this option? So, pulling up your option chain, pulling up a quote, if the answer is yes, then your likelihood of assignment is low. If the answer is no, then your likelihood of assignment drastically increases, and remember you sold an option so you're obligated to fulfill the terms of that option at any time. The question is does it make sense for you to fulfill those terms in the eyes of the person who is driving, which is the long option holder. It's a great question. And I think it's important to show some statistics around this. So, 7% of options are actually exercised, 23% expire worthless, and then the excess are traded on the market. And that goes back to that same scenario. The person who is long that option paying attention to your surroundings, does it make sense for them to own those shares, or do they have the capital to own those shares?

(24:50):

Depends on the strict price, and the other person, and you don't know that information, but if there is a market, there's a lot of volume, there's liquidity they normally can sell to close that option for that intrinsic value component. If they cannot, then there is a likelihood of exercise, subsequent assignment occurring. But what's important to note here, having an option expire worthless may be your goal. In the case of a covered call, that's where you realize your maximum profit potential is the underlying just reaches your maximum strike price, and then it stops there. That's an expiring worthless option, which is good, maximum profit potential for the terms of a covered call, or the covered call option trader. Whereas the long option holder that is not for them, and that would expiring worthless would just exit that security from their account. So, options can be purchased on the secondary market purchased to open, they can be sold to open, they can also be purchased to close, and sold to close.

(25:55):

And you can do that before expiration. And when holding an option till expiration requires this layer, or this level of extra attention, because now you have an option where we have to understand what can we do on the day of expiration? Is it in the money? Is it out of the money? Is it close to the money? Will it move there by the end of the day? And that requires a lot of attention, which could equate to risk. But that's also why I love to start this presentation with understanding extrinsic value, because when we're purchasing an option, time value is working against us, and holding an option till expiration means time value is completely gone. When we're short an option that just increases our risk that we're in maximum profit potential, but it could move adversely at any time. So, the day of expiration adds risk to your option, which requires extra attention. Risk requires attention certainly. So, let's go through what happens the day of expiration.

(26:48):

So, this example, we've got long options, let's focus on that. And ABC stock is at $105 per share. We're going to look at what happens if you hold an in the money option, a near the money option, and an out of the money option. Now, remember, if we're a long option holder, you own the execution rights, you can exercise, you are in the driver's seat. So, we're looking at the driver's seat in this case. Now, if ABC is at 105, you are in the money option. Is that ABC 100 call? So, day of expiration zero days here you can sell to close your option. If a market exists for $5.00 per share, excuse me, $500 total, that's option one. Remember a market has to exist. Two, you could exercise those contracts, but remember that requires capital. Do you have enough capital, or buying power in order to own 100 shares of ABC at $100 per share, or you could submit a do not exercise. What does that mean? We get that question often as well.

(27:55):

On the day of expiration you could say, "I don't want to exercise the terms of this contract, I want to take the obligation, and put it on me." So, what you could do is submit a do not exercise with your firm, and then you are saying, "I intend to settle close these options. I just don't want that exercise to happen." And usually that occurs when you one are holding an option until the day of expiration, and have that increased risk, or two, you do not have the capital required, or don't intend to purchase the shares. You just want to trade them on the market, and you can see the extra risk that happens on the day of expiration. And what your firm can do for you, and lots of firms do this, it's a very big practice, is submit the do not exercise on your behalf, or close out the options, and sometimes you may not even know, and that could be because you hold this option in an account where the exercise could not be supported.

(28:54):

And that could overbuy your account, and lead to a lot of other issues. And that's something that you personally don't want to wake up the next Monday, or the next trading day, and all of a sudden see your account overbought, or in the case of a put could even be a sold stock. And so that's what we mean by heightened risk to pay attention to. If you hold a near the money option, that risk still exists because the option can move in the money, or out of the money really, really quickly. And depending on the events of the day, some unknown, and some known data events that is likely to occur. You could attempt to close, but remember you have a long option so your extrinsic value is gone. If you need to sell to close that option someone else has buy it, whether it's a market maker, an exchange, however that's executed, or someone else, if there's no bid available, you may have a difficult time trying to close that option.

(29:52):

You can also exercise that option wouldn't necessarily make sense in this case. And you could also submit a do not exercise, but the risk still is present with what your firm can do, because you hold a near the money option of expiration, it can move in the money at any time which, and if your account can't support that, then steps might be taken to ensure that doesn't happen, which would be closing out your options on your behalf, or submitting a do not exercise. And again, that could occur without your knowledge, and that's a risk that you take when you're trading options, and holding them to the day of expiration. And then last is holding an out of the money on expiration. Your likelihood of assignment, or excuse me, exercise is low at this point when I say exercise, the OCC accepts there's something called auto exercise that occurs on the day of expiration.

(30:42):

If your option is in the money by at least one penny, it's the way that the clearing firms ensure that you receive that value. And the only way that auto exercise doesn't occur is if you submit contrary instructions, which is that do not exercise that we're speaking of. You can still submit do not exercise, or those contrary instructions regardless if the position is in the money, at the money, or out of the money, because the person who can do that is in the driver's seat only a driver's seat can say do not exercise, there cannot be a do not assign, otherwise, everyone would do that. It doesn't make logical sense. So, in this case, the 110 call, it's out of the money by $5.00 But it could move $5.00. So, you still have that risk, you can allow it to expire, but if it moves adversely, it could put you in a worse situation as in you could be assigned.

(31:38):

There could be a lot happening here, excuse me, exercised. You could submit a do not exercise, and then your firm can have the same negative implications. So, that's something you have to be cognizant in. And the point, or the key takeaway for this is holding an option until expiration, especially if you're a long option holder, you're giving up time value, and when you're giving up time value, that's something that you purchased, you bought to open that option, you bought to open time, you can also sell to close time, and that's something to be cognizant of if you're purchasing options, and that's why it equates to risk on the day of expiration.

David McGann (32:20):

So, Jess, I'm going to jump in again, this is a great slide, and that was a great walkthrough, and I'm going to ask what might be a really silly question, but I'm going to fire away anyways, because we have on the graph here, and I'm looking at the row where it says I hold an out of the money option. Is there ever a use case to exercise an option that is out of the money as your approach, or add expiration? Is there ever a use case to do that, or is that just a really silly idea?

Jessica Inskip (32:51):

That's actually a wonderful question, because there's use cases for so many things, and there's those one-off examples that will certainly go into a little more detail. But again, it's the long option holder doesn't make sense. So, the auto exercise occurs when the option is cut off. Options stop trading normally at 4:00 PM eastern time, and broad-based ETF options are about 4:15, then it varies for index options. So, remember submitting exercise instructions are on the terms of the person who is in the driver's seat, which is the long option holder. There could be some type of event that occurs post 4:00 PM, and there is a window, it's an hour, and a half window where that underlying security could go up in value, there could be a Tweet, or X, formerly Twitter.