Option trading has very basic principles, including optionassignment and exercise, but they can be quite confusing,especially to newcomers. You can easily comprehend some elementsof options because it’s possible to find similarities from yourhistory of stock trading, but these principles don’t belong tothem.
Unlike stock trading, you can use a number of ways to close outoptions. Some of them are based on whether you’re short or long,while others are dependent on your trading goals. Some waysrequire you to give up control, while others provide you with it.First, you need to learn what assignment and exercise are andfind out more about different ways that can be used to close outoptions. Determine when this step should be taken before digginginto more advanced subjects, including dividends and how theyaffect the moment when you close out options. Get moreinformation about differences between option exercise andassignment.
The definition of option exercise
Before breaking out the definition of exercising options, youshould understand who deals with it and who get assignments. Youcan go short or long options, including long and short put, longand short call. For example, if you choose long put or call, youare a buyer who holds the power in this contract. You don’t needto worry about any assignment because you’re dealing withexercising options in this case. If you go short call or put,you’re a seller obligated to meet the requirements of a givencontract, so you need to consider option assignment. If you’re abuyer of options, you can use different ways to close them out,including simply closing options in the market, exercise them, orlet them expire worthless.
How to close out options
Closing out options in the market is the most popular methodbecause you can use it whenever it’s needed and it resemblestrading stocks. Take advantage of this method if:
- You’re short or long your options;
- They are trading at a loss or a profit;
- They’re before or right at their expiration dates.
Basically, you can turn to this method wherever and whenever youwant.
How to let options expire worthless
According to many people, letting options expire worthless is thesimplest method, but this means that you’re taking either a fullgain or a full loss based on a particular position. You canbenefit from this method if:
- Your options are at their expiration;
- You’re either short or long your options.
The main thing that should be remembered about letting optionsexpire worthless is that they must be at their expiration. It’s asituation where you should do nothing or avoid entering anyorders. Options will disappear from your account and expire, andthe best part about it is that you aren’t obliged to cover anycommission to close your position.
The meaning of option exercise
Once you get a clearer understanding of possible ways to closeoptions, you can switch to option exercising. The buyers of calloptions have their right to buy shares at a strike price, andit’s a key definition of call options because it deals with theright to exercise options. In other words, exercising calloptions trades them in for the underlying. The buyers of putoptions have their right to sell shares at their strike price,similarly to the above-mentioned principle. This means thatexercising put options trades them in for a short share. It’spossible to exercise your options if you’re long put or calloptions. There’s only one requirement that must be met, but thereare certain rules that dictate when you should exercise options.
Basic option exercise rules
These rules can help you benefit from exercising options, butthere are some exceptions that should be kept in your mind.First, don’t exercise options that are out-of-the-money becausethe main purpose is to earn a profit. You shouldn’t exerciseoptions before their expiration because you will only forfeit theproperties of those options that you’ve already paid for. That’sbecause you will forfeit their time value and insurance.
How to exercise your options
Most brokerages have a special button on a trading platform thatguarantees easy options exercising. Others make you call in andlet them known whether you want to exercise your options. Forexample, if options are slightly in-the-money, they will beautomatically exercised at their expiration. If you don’t want toexercise options, close them out at their expiration.
The definition of assignment in option trading
Option assignment is a flip-side of option exercising. Whenconsidering the latter one, only buyers can take part in thisprocess. When they decide to exercise options, sellers areassigned. When you’re short options, both put and call, you don’thave any choice or right to assign them. On the contrary, youhave your obligation to fulfill assignments when buyers exerciseoptions. What does it mean?
If you’re short a call, and buyers decide to exercise or tradeoptions for shares, it’s necessary to sell them shares. If youhold them in a personal trading account, you will lose someshares and buyers will get them. If you don’t hold shares, youwill be short them and buyers will get them. Furthermore, ifyou’re short a put when buyers decide to exercise or tradeoptions for short shares, you need to buy them. You end up beinglong shares in a personal account instead of holding options.
The process of matching sellers and buyers
The process of matching sellers and buyers for assignments andexercising is done at random. The brokerage of buyers informs theOCC that there’s an exercise notice, and the OCC finds anotherbrokerage that meets all requirements to fulfill optionexercising. It’s obliged to place a special assignment notice toaccount holders who are short these options. In general, youshouldn’t be concerned with being assigned when options areout-of-money. Although they may not be at their expiration, ifoptions are in-the-money, you must be ready for assigning becauseit’s quite likely to happen before their expiration. Basic rulesaren’t always followed by everyone, but you shouldn’t let yourin-the-money options reach their expiration because they will beassigned.
Important facts to mention
Option assignment happens when options are exercised by theirholders, and their writers are assigned the requirement todeliver the terms of a particular contract.
- When call options are assigned, their writers need to sellthe required quantity of underlying security at a strike price;
- When put options are assigned, their writers need to buy thenecessary quantity of underlying security at a strike price.
When options are sold, there’s a possibility for their writers tobe assigned to meet their requirement to sell or buy the sharesof underlying stocks. It’s almost impossible to tell whenassignments take place. To guarantee their fair distribution, theOCC uses a random procedure for assigning exercise notices totrading accounts. In turn, all assigned firms need to use theexchange-approved way to allocate these notices to personalaccounts with short positions of given options.
In most cases, options are exercises when they get closer totheir expiration. The main reason is that it doesn’t make senseto exercise options with a time value. Short options, both putand call, can be assigned whenever you want if they arein-the-money. When selling put options, sellers give the rightfor put owners to sell them stocks at a given price and in agiven time period. Selling call options provides the right tocall owners to buy stocks away from sellers within a specifictime frame. The buyers of options have their right to exercisein-the-money options whenever they want before their expiration,but they aren’t obliged to do that. Short options are oftenassigned if they expire in-the-money or when there’s any dividendpaid out.
Selling short put options
When selling short put options, sellers give the right to putowners to sell them stocks at a set price and within a given timeframe. If their strike price is in below the current market one,option holders don’t gain any value when putting stocks tosellers as the market value is greater than their strike price.If the latter one is above a market price, option sellers are atan assignment risk.
Selling short call options
When selling call options, call owners get the right to buystocks away from sellers in a given period of time. If theirmarket price is below a strike price of options, call holdersdon’t benefit from calling stocks away at a higher market value.If it’s greater than a strike price, option holders call awaystocks at a lower market value. Short calls are at a higherassignment risk when they’re in-the-money and when there’s adividend and their extrinsic value is less than it.
The impact of dividends on early assignments
As you already know, there are certain exceptions to basic rules,and they come in the form of dividends. Options neither pay outnor collect them, so it’s necessary to hold or short stocks tocollect and pay dividends. Another important requirement is to dothat only on the ex-dividend date, and this is when companiesrecord all shareholders to pay them dividends. If you buy stocksafter this date, you won’t receive any dividends.
If there’s only a little time value left in your in-the-moneyoptions, it’s possible to exercise them to gain a profit anddividends. If you’re short options, you need to know whencompanies have their ex-dividend date. You can look at earlyassignments if you aren’t prepared, and the simplest method is tosimply close out such options before they get to this date.
Many option traders are caught up in what happens at theirexpiration or if they want to exercise options to gain a profit.Luckily, you can use better solutions that don’t force you towait, including buy or sell to close orders.
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