Option trading has very basic principles, including option assignment and exercise, but they can be quite confusing, especially to newcomers. You can easily comprehend some elements of options because it’s possible to find similarities from your history of stock trading, but these principles don’t belong to them.
Unlike stock trading, you can use a number of ways to close out options. Some of them are based on whether you’re short or long, while others are dependent on your trading goals. Some ways require you to give up control, while others provide you with it. First, you need to learn what assignment and exercise are and find out more about different ways that can be used to close out options. Determine when this step should be taken before digging into more advanced subjects, including dividends and how they affect the moment when you close out options. Get more information about differences between option exercise and assignment.
The definition of option exercise
Before breaking out the definition of exercising options, you should understand who deals with it and who get assignments. You can go short or long options, including long and short put, long and short call. For example, if you choose long put or call, you are a buyer who holds the power in this contract. You don’t need to worry about any assignment because you’re dealing with exercising options in this case. If you go short call or put, you’re a seller obligated to meet the requirements of a given contract, so you need to consider option assignment. If you’re a buyer of options, you can use different ways to close them out, including simply closing options in the market, exercise them, or let them expire worthless.
How to close out options
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Closing out options in the market is the most popular method because you can use it whenever it’s needed and it resembles trading 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 you want.
How to let options expire worthless
According to many people, letting options expire worthless is the simplest method, but this means that you’re taking either a full gain or a full loss based on a particular position. You can benefit 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 options expire worthless is that they must be at their expiration. It’s a situation where you should do nothing or avoid entering any orders. Options will disappear from your account and expire, and the best part about it is that you aren’t obliged to cover any commission to close your position.
The meaning of option exercise
Once you get a clearer understanding of possible ways to close options, you can switch to option exercising. The buyers of call options have their right to buy shares at a strike price, and it’s a key definition of call options because it deals with the right to exercise options. In other words, exercising call options trades them in for the underlying. The buyers of put options have their right to sell shares at their strike price, similarly to the above-mentioned principle. This means that exercising put options trades them in for a short share. It’s possible to exercise your options if you’re long put or call options. There’s only one requirement that must be met, but there are certain rules that dictate when you should exercise options.
Basic option exercise rules
These rules can help you benefit from exercising options, but there are some exceptions that should be kept in your mind. First, don’t exercise options that are out-of-the-money because the main purpose is to earn a profit. You shouldn’t exercise options before their expiration because you will only forfeit the properties of those options that you’ve already paid for. That’s because you will forfeit their time value and insurance.
How to exercise your options
Most brokerages have a special button on a trading platform that guarantees easy options exercising. Others make you call in and let them known whether you want to exercise your options. For example, if options are slightly in-the-money, they will be automatically exercised at their expiration. If you don’t want to exercise options, close them out at their expiration.
The definition of assignment in option trading
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Option assignment is a flip-side of option exercising. When considering the latter one, only buyers can take part in this process. When they decide to exercise options, sellers are assigned. When you’re short options, both put and call, you don’t have any choice or right to assign them. On the contrary, you have your obligation to fulfill assignments when buyers exercise options. What does it mean?
If you’re short a call, and buyers decide to exercise or trade options for shares, it’s necessary to sell them shares. If you hold them in a personal trading account, you will lose some shares and buyers will get them. If you don’t hold shares, you will be short them and buyers will get them. Furthermore, if you’re short a put when buyers decide to exercise or trade options for short shares, you need to buy them. You end up being long 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 and exercising is done at random. The brokerage of buyers informs the OCC that there’s an exercise notice, and the OCC finds another brokerage that meets all requirements to fulfill option exercising. It’s obliged to place a special assignment notice to account holders who are short these options. In general, you shouldn’t be concerned with being assigned when options are out-of-money. Although they may not be at their expiration, if options are in-the-money, you must be ready for assigning because it’s quite likely to happen before their expiration. Basic rules aren’t always followed by everyone, but you shouldn’t let your in-the-money options reach their expiration because they will be assigned.
Important facts to mention
Option assignment happens when options are exercised by their holders, and their writers are assigned the requirement to deliver the terms of a particular contract.
- When call options are assigned, their writers need to sell the required quantity of underlying security at a strike price;
- When put options are assigned, their writers need to buy the necessary quantity of underlying security at a strike price.
When options are sold, there’s a possibility for their writers to be assigned to meet their requirement to sell or buy the shares of underlying stocks. It’s almost impossible to tell when assignments take place. To guarantee their fair distribution, the OCC uses a random procedure for assigning exercise notices to trading accounts. In turn, all assigned firms need to use the exchange-approved way to allocate these notices to personal accounts with short positions of given options.
In most cases, options are exercises when they get closer to their expiration. The main reason is that it doesn’t make sense to exercise options with a time value. Short options, both put and call, can be assigned whenever you want if they are in-the-money. When selling put options, sellers give the right for put owners to sell them stocks at a given price and in a given time period. Selling call options provides the right to call owners to buy stocks away from sellers within a specific time frame. The buyers of options have their right to exercise in-the-money options whenever they want before their expiration, but they aren’t obliged to do that. Short options are often assigned if they expire in-the-money or when there’s any dividend paid out.
Selling short put options
When selling short put options, sellers give the right to put owners to sell them stocks at a set price and within a given time frame. If their strike price is in below the current market one, option holders don’t gain any value when putting stocks to sellers as the market value is greater than their strike price. If the latter one is above a market price, option sellers are at an assignment risk.
Selling short call options
When selling call options, call owners get the right to buy stocks away from sellers in a given period of time. If their market price is below a strike price of options, call holders don’t benefit from calling stocks away at a higher market value. If it’s greater than a strike price, option holders call away stocks at a lower market value. Short calls are at a higher assignment risk when they’re in-the-money and when there’s a dividend 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 out nor collect them, so it’s necessary to hold or short stocks to collect and pay dividends. Another important requirement is to do that only on the ex-dividend date, and this is when companies record all shareholders to pay them dividends. If you buy stocks after this date, you won’t receive any dividends.
If there’s only a little time value left in your in-the-money options, it’s possible to exercise them to gain a profit and dividends. If you’re short options, you need to know when companies have their ex-dividend date. You can look at early assignments if you aren’t prepared, and the simplest method is to simply close out such options before they get to this date.
Many option traders are caught up in what happens at their expiration or if they want to exercise options to gain a profit. Luckily, you can use better solutions that don’t force you to wait, including buy or sell to close orders.
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