For reasons that I don’t understand many rookie option traders fear being assigned an exercise notice on a previously sold option.
In this options trading article we’ll examine why that assignment notice is a free gift. That gift is likely to be worthless, but on occasion it turns out to be a very welcome surprise.
Looking at a common situation, suppose that you have written a covered call. You owned 300 shares of YFS (Your Favorite Stock Inc.), watched it rally, and finally decided that it’s time to sell the shares because you believe they are fully priced at $41 per share.
Instead of selling the shares outright, you decided to milk this trade for additional profits and wrote three YFS March 40 Calls, collecting a premium of $2.50. If the stock is above $40 when expiration arrives, you will sell the shares at $40. Adding the option premium, your net is $42.50 instead of $41. Sure, there’s some downside risk prior to expiration, but you decide to accept that risk.
All goes well, the stock rallies further and when it’s trading at $44, you are surprised to be assigned an exercise notice because it’s one week before expiration. There was no reason for the option owner to exercise and the stock did not go ex-dividend. Nevertheless, you sold your stock, earned your profit and even collected the cash one week early. This is all good.
In most cases that’s the end of the story. However, on this occasion you learn the importance of not exercising an option earlier than necessary. On Monday and Tuesday of expiration week, overseas markets tumbled and the U.S. market followed suit. On top of that, YFS issues some minor news that, under ordinary market conditions, would have been shrugged off. However, with the nervous market and a substantial two-day decline, YFS fell out of bed. When the market opened Wednesday morning, it was trading south of $37 per share.
If you had not been assigned early, you would own stock and have no chance to sell at $40. So give a big “thank you” to the person who made the terrible decision to exercise.
Think of it this way — it’s exactly the same as if the person who exercised your calls said to you:
“Here is a FREE put option. I’m taking your stock now and in its place you now own three March 40 YFS put options. If the stock trades below $40 next week, you will have the right to sell those shares at $40. In reality you already sold the shares, but because most stockholders were not assigned an exercise notice, I’ve given you a special gift: three put options. I did this because I am certain these puts are worthless, but they are yours with my compliments.”
Of course, the exerciser does not truly think that way or else he/she would have never exercised early. This time you were saved from taking a loss. If YFS dips low enough that you want to repurchase the shares, you are in position to do so. If you still owned the original shares, you would not have the ready cash to make that choice.
Being assigned on a call option is the same as being handed a free put. Being assigned early on a put option is equivalent to being handed a free call. These “imaginary, free” options have the same strike and expiration date as the real options on which you were assigned.
Don’t be unhappy when assigned. It can be a rare gift.
Follow Mark Wolfinger on Twitter @MarkWolfinger.
