- 2001: Volume 10, No. 4 Puts & Calls: The Lowdown on Assignment

Assignment is one of the more confusing characteristics of an option. Although it occurs infrequently, it is an important part of basic option mechanics. All option traders need to have a solid understanding of assignment in order to maximize their chances for success.

Assignment is the term used to describe the option writer’s (seller’s) obligation to sell or buy stocks or other financial instruments at the strike price for which they sold the contract. The buyer of an option has the right (but not the obligation) to exercise the option, i.e., buy the underlying asset at the strike price of the contract (long call); or sell, (deliver) the underlying asset to the option writer at the strike price of the contract (long put).

For example, let’ say you take out a bull call vertical spread on ABC stock by purchasing the $10 contract and selling the $20. If you’re assigned, you will have to deliver the stock to the buyer for $20, even if the market value is higher. If you don’t own the stock, you will have to go into the cash market and buy the stock at market in order to honor the assignment. This is what makes selling naked options dangerous. With a spread, you are protected. Even if you don’t own the stock, you simply exercise the long call at $10 (just as the buyer of your sold option exercised their right to buy the stock from you at $20) and deliver said stock to the assigned option buyer. In return, you receive $20 per share. Your maximum gross profit is the difference between the strikes—$10-minus the cost of the long contract plus commissions.

Assignment on written puts is the opposite transaction. The option seller is obliged to buy the stock from the assigned option buyer at the short strike price. For example, let’s say you decide to place a bear put vertical spread by purchasing an ABC put option at $30 and selling a put option at $20. If the buyer of your $20 contract decides to exercise their option, they will deliver the stock to you for $20 per share; thus, you are obliged to buy the stock at $20 even though the market value is most likely less than $20. You can of course exercise your long put and deliver the stock to writer of your $30 put contract, creating a maximum gross profit of $10 less the price of the long put plus commissions.

Generally speaking, traders usually don’t wait to make the maximum profit which almost certainly means holding the spread until expiration. If a trader has made 80 percent on their trade, and the underlying asset is now past the strike price of the short option, most traders simply close out the spread and look for the next trade. In real-world trading, assignment is pretty much automatic if the short options are in-the-money by expiration.

Bull call spreads are less likely to be assigned before expiration than bear put spreads; you’re more likely to have stock delivered before expiration when a short put goes deep-in-the money than for a buyer to ask for delivery of the stock. Warren Buffett is one of the few big trader/investors I know of, who sells naked puts because he doesn’t mind receiving delivery of the stock if the put goes deep in-the-money. New Market Wizards has a cautionary tale that explains why waiting until expiration in the hope that the underlying asset won’t be delivered can turn into a poker game of calling the other trader’s bluff.

Bill Lipschutz, whom Jack Schwager dubbed "The Sultan of Currencies" in his New Market Wizard book told Schwager the following story:

"I had put on a huge option spread position: long twenty-three thousand Japanese yen 54 calls and short twenty-three thousand calls. If the calls expired in-the-money, each side of the spread would represent nearly million—an enormous position at the time. When I put on the position, the calls were well out-of-the-money."

Schwager notes that the biggest risk on a bull call spread was when the price at expiration fell between the strikes. The long call would automatically be exercised but the short call might not be assigned, leaving the trader with tremendous exposure to an adverse move in the markets.

In Liptschutz’s case, that would not be until the Tokyo market opened on Sunday night—Although currencies trade around the world 24 hours a day, in keeping with the date line, individual markets close on a Friday and re-open on a Sunday. It should also be noted that just because currency markets are awake 24/7, it doesn’t necessarily mean you want to trade everywhere; some market conditions are clearly more favorable than others.

Litpschutz describes the cat-and-mouse game that ensued on the day of expiration and the day after. On the day of expiration, the yen was 1 tick away from the 55 strike. He had no idea what the other side was going to do. He thought they’d exercise their long calls but he couldn’t be sure. Then he was tipped off that the other side was buying yen in the cash market, i.e., hedging their short position. He continued in his conversation with Schwager:

"At 5:00 p.m., the yen closed within one tick of the 55 strike level. Because of the other firm’s actions in the cash market, I thought they probably wouldn’t exercise their long 55 calls, but I couldn’t be certain.

"On Saturday, the phone rang and it was the other firm’s trader. ‘How are you doing?’ I asked.

"‘Very good. How are you doing?’ he asked in return.

"‘I don’t know, you tell me,’ I answered. Remember, you don’t get your notices until Sunday, and this conversation was taking place on Saturday. ‘What did you do?’ I asked.

"He said, ‘What do you think I did? You’ll never guess.’

"‘Well, I think you kind of tipped your hand on Friday afternoon,’ I answered.

"‘Yeah, that was the stupidest thing,’ he said. The purchase of yen in the interbank market hadn’t been his decision; it was a committee decision at his company. He finally told me, ‘We’re not going to exercise.’"

The rest of the analysis that Lipschutz offers in response to Schwager’s question "did he just call to let you know that they weren’t going to exercise and let you off the hook?" is worth reading. Lipschutz stood to gain million for his firm, Salomon Brothers, if the spread closed in his favor, i.e., if it closed above the 55 strike.

As previously mentioned, automatic exercise is all but guaranteed if the option is in-the-money at expiration. The challenge that Schwager described applies to regular stock options accounts as well. Most firms will automatically exercise the long call if it expires in-the-money, even by a fraction, in order to protect themselves against clients who might come after them for not having exercised. They have until 4:00 p.m. Saturday to exercise the option if they are going to buy or sell the underlying asset; which means your short position is still hedged because you now own the underlying asset itself. If the buyer of your short call exercises their right to buy, you simply deliver the stock that your firm automatically purchased at the strike price of the long call. However, if you are not assigned, you have the same exposure to an adverse move in the direction of the underlying asset when the markets open again, since the move at expiration was fractional.

Note: the timing for exercise is different from simply closing out the spread or closing out a simple long call. If you are not going to exercise the long option, i.e. buy or sell the underlying asset, and it is in-the-money, you must close out your spread or simply long position before the markets close on Friday. In the case of the stock market, that means 4:00 p.m. Friday; otherwise the options expire worthless. In other words, you don’t have an extension if you’re simply collecting premium.

All spreads contain the possibility of assignment, but traders usually don’t wait until expiration; unless the reward is significant, such that it would be beneficial to wait until expiration to close out the position. However, in the case of Lipschutz, having bet and not quite won, closing out a huge position in the final hours of trading before expiration would have cost him far more than the assignment.

A trade where assignment before expiration seems obvious is a call ratio backspread, where typically you sell one at-the-money call and buy two out-of-the-money calls for a credit or free trade (not including commissions). Here, you are deliberately holding the trade to go beyond the strike price of the long calls, therefore, you risk being assigned as the short call moves deep in-the-money. For example, let’s say you sell one 10 strike call and buy two calls at 20. Once the underlying asset is beyond 20, the risk of assignment comes into play. Theoretically, however, the cost of delivering stock at a price lower than its market value, i.e., at now that it’s over , is usually offset by the premium from the first long call that hedged the short call. And typically, the trader won’t wait for assignment (which in this case is not likely until expiration); they’ll simply close out the spread, leaving the single directional option to run freely, for maximum profit.

Understanding the ins and outs of assignment and how it works it real-world trading is vital to becoming a successful options trader. I highly recommend sharing your assignment experiences on the Optionetics.com message boards to get the most out of what you’ve learned and reap the benefits of the lessons learned by your fellow traders.

Shelley Souza is a senior writer and trading strategist for www.optionetics.com—your options education site. Visit Shelley Souza’s Forum at www.optionetics.com.