Definition and examples of assignment
How does assignment work?
What does this mean for individual investors?
Definition and examples of assignment
Option assignment represents the obligation of the option writer to fulfill the terms of the contract by selling or buying the underlying security at the strike price. Let’s explain this in more detail.
Assignment represents the obligation of the option writer to fulfill the terms of the contract by selling or buying the underlying security at the strike price. Let’s explain this in more detail.
When you sell an option to someone, you are selling them the right to make a future transaction. For example, if you sell a put option to someone, you are promising to buy a share at a specified price at any time between the transaction and the option’s expiry date.
If the option holder does nothing regarding the option by expiration date, the option expires. However, if they decide that they want to exercise the option, they will do so.
If the option holder decides to exercise the option, the seller will receive a notice called an assignment, informing them that the option holder is exercising their right to complete the transaction. The seller is legally required to fulfill the terms of the option contract.
For example, if you sell a call option on XYZ stock with a strike price of $40 and the buyer decides to exercise the option, you will be assigned the obligation to execute that contract. You will have to buy 100 shares of XYZ at whatever the current market price is, or take the shares from your own portfolio and sell them to the option holder at $40 per share.
Note: Options traders only need to worry about assignment if they are selling option contracts. Those who buy options do not need to worry about assignment because, in this case, they have the option to either exercise the contract or not.
How does assignment work?
The options market is huge, with options being traded on major exchanges, and you likely don’t know from whom you are buying the contracts or to whom you are selling them. It’s not like you’re selling an option to someone you know who will email you if they choose to exercise the contract; it’s an organized process.
In the United States, the Options Clearing Corporation (OCC), which is viewed as the clearing house for the options industry, facilitates the exchange of options contracts. It ensures a fair process for assigning options, including fulfilling contract obligations.
When an investor chooses to exercise the contract, the OCC assigns the obligation to one of the people who sold the exercised option. For example, if 100 people sold options on XYZ at a strike price of $40, and one of those options is exercised, the OCC will randomly assign that obligation to one of the 100 sellers.
Note: Generally, assignment is rare. About 7% of options are exercised, with 93% expiring. Assignment becomes more common as the expiration date approaches.
If you are assigned the obligation to fulfill the option contract you sold, it means you must accept the associated loss and execute the contract. Typically, your broker will handle the transaction on your behalf automatically.
What does this mean for individual investors?
If you are an individual investor, you only need to worry if you are involved in selling options. Even then, assignment is not very common. Less than 7% of options are assigned, and they are assigned as the expiration date nears.
Option assignment means you have to lock in the loss on the option, which can be painful. However, if you are really concerned about assignment, you can plan to close your position sometime before the expiration date or use option strategies that do not involve selling options that can be exercised.
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Sources:
The Options Industry Council. “Options Assignment FAQ: How Can I Tell When I Will Be Assigned?” Accessed Oct. 18, 2021.
Source: https://www.thebalancemoney.com/what-is-an-option-assignment-5206209
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