WHAT IS ASSIGNMENT IN OPTIONS?

 

What is Assignment in Options?

   Options trading can be a highly effective and flexible investment strategy, but it's crucial to understand the key concepts involved, one of which is assignment. Assignment occurs when the seller of an option is obligated to fulfill the terms of the contract. This concept applies to both call options and put options. When an option buyer exercises their rights, the seller (or writer) is "assigned" the obligation to act on the contract. In this article, we will explore assignment in options trading in detail, including how it works, the risks involved, and strategies traders can use to manage assignment.

Understanding the basics of options

To fully grasp the concept of assignment, it's essential first to understand what options are. An option is a financial derivative that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (known as the strike price) before or at the expiration date. There are two primary types of options:

Call option:  Gives the buyer the right to buy an asset.

Put option:  Gives the buyer the right to sell an asset.

   The seller or writer of the option, on the other hand, is obligated to fulfill the contract if the buyer exercises the option. This is where assignment comes into play.

What is Assignment?

   Assignment happens when the option buyer chooses to exercise their option. Upon exercising, the option writer is required to take the corresponding action. For a call option, this means the writer must sell the underlying asset at the strike price to the buyer. For a put option, the writer must buy the underlying asset at the strike price.

Assignment in call options

   Let’s say you are the writer of a call option, and the buyer decides to exercise it. If this happens, you are assigned and must sell the underlying asset to the buyer at the strike price, even if the current market price is higher.

Example:

Stock price:  Rs.60

Strike price of the call option:  Rs.50

   If the buyer exercises the option, you must sell the stock to the buyer at Rs.50 (lower than its current price of Rs.60). This is potentially a loss for the option writer.

Assignment in put options

   For put options, if the buyer exercises their right to sell, the option writer is assigned the obligation to buy the underlying asset from the buyer at the strike price, even if the current market price is much lower.

Example:

Stock price:  Rs.40

Strike price of the put option:  Rs.50

   If the buyer exercises, you must buy the stock at Rs.50, which is higher than the current market value of Rs.40, resulting in a potential loss for the option writer.

How assignment works

   The process of assignment involves various steps and key players in the options market.

Exercise by the buyer:  When the holder of an option decides to exercise it, they notify their broker.

Clearing corporation:  The broker, in turn, notifies the clearing corporation . The OCC plays a crucial role in ensuring smooth and transparent transactions in the options market.

Random assignment:  The OCC assigns the exercise to a specific option writer. The assignment process is random to ensure fairness, meaning that if you wrote an option, you could be assigned at any time if the option holder exercises.

Early assignment:  American vs. European Options

   The timing of assignment is determined by the type of option involved—American or European.

   American-style options allow the buyer to exercise the option at any time before the expiration date. This means the writer of an American option is at risk of being assigned at any point after the option is sold until the expiration.

   European-style options can only be exercised on the expiration date. Therefore, assignment can only occur on that specific day.

Risks of assignment

   Being assigned carries several risks for option writers. These risks vary depending on the type of option written—call or put—and the current market conditions.

1. Market risk

   If a call option is assigned and the market price is much higher than the strike price, the writer will be forced to sell at a lower price, resulting in a loss.

   In the case of a put option, the writer may have to purchase the asset at a higher price than the current market value, leading to a potential loss.

2. Loss of dividends

   Call option writers face the risk of losing out on dividends if the buyer exercises the option before an ex-dividend date. This early assignment may force the seller to deliver the stock just before the dividend payout, thus forfeiting the right to collect the dividend.

3. Margin requirements

   Assignment can trigger margin calls, as the option writer must cover the costs of buying or selling the underlying asset. This can be a particular issue for put option writers, who may need to buy the stock at the strike price.

How to Manage Assignment Risk

   While assignment is a natural part of options trading, there are several strategies that traders can use to manage and mitigate assignment risk.

1. Covered Call Writing

   In a covered call strategy, the option writer owns the underlying stock. This limits the risk of assignment, as the writer can deliver the stock if the call option is exercised.

Example:

   If you own 100 shares of a stock trading at Rs.50 and write a call option with a Rs.55 strike price, the most you risk is selling your stock at Rs.55, even if the market price increases further.

2. Cash-secured put writing

   For put options, traders can use a cash-secured put strategy. This involves setting aside enough cash to buy the underlying stock at the strike price if assigned.

Example:

   If you write a put option with a Rs.40 strike price, having Rs.4,000 set aside for buying 100 shares will cover the obligation if you are assigned.

3. Rolling options

   Traders can avoid assignment by rolling their options positions. Rolling involves closing out an existing position (buying back the option) and opening a new one with a later expiration date or a different strike price.

Example:

   If you sold a call option and the stock price is approaching the strike price, you can roll the position to a higher strike price to avoid assignment.

4. Early exit

   Another strategy is to close out the option before the risk of assignment becomes imminent. This might involve buying back the option before it gets too close to the expiration date.

Conclusion

   Assignment is an essential concept for anyone involved in options trading. It’s the process by which the writer of an option is obligated to fulfill the terms of the contract when the buyer exercises their rights. While assignment is more common with American-style options due to the possibility of early exercise, it can happen at any time before expiration.

   The risks of assignment, including market risk, loss of dividends, and margin requirements, can be significant. However, there are strategies like covered call writing, cash-secured puts, and rolling options that traders can use to manage these risks.

   Ultimately, understanding assignment and its implications can help traders make informed decisions and create more effective strategies in the options market. By being aware of the risks and implementing proper risk management techniques, options traders can enhance their trading performance and reduce unwanted surprises.