Early Exercise of Equity Options

It is inevitable that you will be assigned on an option position throughout your option career. The crucial element in dealing with these situations is knowing what an assignment will do to your current position(s). Upon being notified of an assignment, you will be instructed as to what was exercised, and how many shares of stock you are currently long or short (short with a call assignment/long with a put assignment). Now you must decide what to do, if anything.

Also, it is important to note that the call you sold may have been bought by one individual; however, the assignment may have come from another individual. This last statement may not make sense at first, but one must understand how the OCC (Option Clearing Corporation) works in order to understand this. Once an early exercise notice is handed into the OCC, the OCC randomly decides who is to be assigned. This process is done by lottery to ensure of fairness to all short option positions. Thus, you may have sold the call to trader “X”, but trader “Y” submitted an exercise notice that was processed by the OCC and assigned to you.

When short a call option, you are at risk of being assigned at anytime. This usually does not occur unless it is more profitable for the owner of the call to own stock, than it is to own the call. This often happens around dividend periods and close to expiration.

The owner of the call option decides that it is in his interest to exercise the call in order to buy stock. As the owner of the call option has all the rights, and the seller of the call has all of the obligations, you will be forced to deliver or sell stock to the call owner.

The writer of the call will be assigned a short stock position. As the owner of the call has the right to buy stock, and the seller has the obligation to sell, you must sell the stock to the individual who elected to exercise his long call. As there is still time remaining until expiration, you have some form of risk, even if you should have an option position protecting short stock. (i.e. long call). If you do not have any other positions other than the short stock, you will have the exact same risk characteristics of a short stock position.

Example:

The most common form of early call exercise comes from the position known as a covered call, or “buy-write.” A covered call is simply a position consisting of long stock and a call sold against the stock position to enhance the profitability of the stock position.

If one has a covered call position that is perfectly covered (one call for every hundred shares of stock), one will see one’s entire position disappear after an assignment. As the seller of the call, you are obligated to deliver stock when called upon. As you currently own the stock, the stock you own is simply taken away and given to the call buyer. You are forced to sell the stock at the strike price. All that will be left over from this position movement is the net profit or loss from the trades (stock purchase, call sale, assignment).

Your profit/loss will be found by using the following formula:

Stock sale price (assignment strike)      ___________
Minus the stock purchase price            ___________
Plus the option premiums received       ___________
Minus commission costs                      ___________
Equals net profit/loss                           $__________

Example:

This is hardly a problem to most traders; however, some long-term investors are now at a disadvantage. They are forced to sell a stock that they may have owned for some time, thus they will have capital gains tax issues. If the investor purchased the stock for $5 a share a few years ago, and the stock is currently at $55, the investor has $50 per share above the purchase price locked-in, and he will have to pay tax on this.

To get around this, many individuals (such as Warren Buffett) elect to trade index options instead. Another tactic that people use, which is far from foolproof, is to simply buy the call back once very little time value is left in the short call position.

When short a put option, you are at risk of being assigned at anytime. This usually does not occur unless it is more profitable for the owner of the put to sell stock, than it is to own the put. This often happens around dividend periods and close to expiration.

The owner of the put option decides that it is in his best interest to exercise the option in order to sell stock. As the owner of the put option has all the rights, and the seller of the option has all of the obligations, you will be forced to take delivery of, or buy stock from the put owner.

The writer of the put will be assigned a long stock position. As the owner of the put has the right to sell stock, and the seller has the obligation to buy stock, you must buy the stock at the strike price from the individual who elected to exercise his long put. As there is still time remaining until expiration, you have some form of risk, even if you should have an option position protecting the long stock. (i.e. long put). If you do not have any other positions other than the newly acquired long stock, you will have the exact same risk characteristics of a long stock position.

Example:

Should the stock be trading for less than the strike price, which it most assuredly will be, the profit or loss can be easily calculated by taking the current price of the stock and subtracting the strike price of the put sale, and adding the premiums received to the strike price. If one sold the 80-strike put at $5, we could calculate the loss on this position to be $10 ($65 – $80 + $5 = -$10) if we know the stock is trading at $65 per share.

Your profit/loss will be found by using the following formula:

The current stock price ___________
Minus Stock purchase price (assignment strike) ___________
Plus the option premiums received ___________
Minus commission costs ___________
Equals net profit/loss $__________