Exercise & Assignment

[Igor 10]

When an investor buys an option, they have the right to exercise it at any time before it expires. After a buyer exercises their option, the brokerage house assigns the obligation to seller's assets. The strike price is the value an option seller (writer) will use when buying or selling shares to meet their obligations.

 

Exercising Options

Buyers purchase call orders or put orders in the options market. The buyer then has until the day the option expires (normally 30 days) to exercise it, sell it or let it expire. Option buyers are not obligated to exercise their contract, but if they choose to do so, they obligate the writer to either buy or sell assets to cover the contract.

 

Assigning Call Options (Obligating a Sale)

Traders who sell call options are betting that the market price of the underlying asset will go down. Buyers can exercise their contract at any time when the market price is above the option's strike price.

Once exercised, the Options Clearing Corporation (OCC) assigns the obligation to "SELL" shares to the writer at the strike price. If the writer does not own the shares, they will need to buy them in the open market at a price higher than the strike price to cover the sale.

 

Example

1) Call seller writes the option: GEJan50($2) = 100 shares of GE stock at $50/per share (strike price), expiring on 1/15 (strike date) with a premium cost of $2.

2) GE's Market price hits $60 and buyer exercises the option.

3) The OCC assigns the "SELL" obligation to the writer.

 

Results one: If the writer owns the shares (covered call), they simply sell them to the buyer for $50 to cover the contract. They will receive $5000 and will keep $200 in premiums.

 

Results two: If the writer does not own the shares (naked call), they'll need to buy 100 shares at the market price of $60 to sell to the buyer. The total the writer will pay is $6000. They only receive $5000 from the sale, incurring a total loss of $800 after adding the premiums collected earlier.

 

Assigning Put Options (Obligating a Purchase)

Traders who sell put options are betting that the market price of the underlying asset will rise. Buyers can exercise their contract at any time when the market price is below the option's strike price. Once exercised, the Options Clearing Corporation (OCC) assigns the obligation to "BUY" shares from the writer at the strike price. If the writer does not own the shares, they will need to buy them from the seller at a price lower than what they're worth.

 

Example

1) Put seller writes the option: GEJan50($2) = 100 shares of GE stock at $50/per share (strike price), expiring on 1/15 (strike date) with a premium cost of $2.

2) GE's Market price hits $40 and buyer exercises the option.

3) The OCC assigns the "BUY" obligation to the writer.

 

Results one: Traders who short sell their shares write put orders (covered put), to protect (hedge) them. When the market price hit $40, their short shares gained $1,000 in intrinsic value. The writer then sells their shares at market value for $4000. Adding the $1,000 they gained from the short, they use the $5000 to cover the contract. They receive their 100 shares back and keep $200 in premiums.

 

Results two: If the writer does not own the shares (naked put), they'll need to buy 100 shares from the buyer at $50, paying $5,000. Unfortunately, the shares are only worth $4,000 (market value). The $200 in premiums collected earlier reduce the $1,000 loss to $800.

 

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