Exercise and Assignment, Early or Otherwise
If you trade options, it's imperative that you understand the basics of exercise and assignment. You don't need to know all the theoretical details, but you must be prepared for it, especially if you're short options where you don't control the exercise feature.
Exercise is the term used when the owner of a call or put (i.e. someone who has a long position in a call or put) uses his right to buy (in the case of a call) or sell (in the case of a put) the stock. Assignment is the term used when someone who is short a call or put is forced to sell (in the case of the call) or buy (in the case of a put) the stock. Remember, for every option trade there is a buyer and a seller, so if you are short an option, there is someone out there who is long that option and who could exercise.
As you know from the basic definition of options, a call gives its owner the right, but not the obligation, to buy the stock at the strike price. But the seller of a call must sell the stock at the strike price whenever the call owner exercises. A put gives its owner the right, but not the obligation, to sell the stock at the strike price. But the seller of a put must buy the stock at the strike price whenever the put owner exercises.
Remember, on expiration, thinkorswim will automatically exercise any equity option that is $0.01 or more in-the-money.
American-style options can be exercised as soon as they are purchased and all the way up to the expiration date. European-style options can be exercised only on the last trading day before the expiration date. All equity options traded in the U.S. are American-style. But some index options are American-style (OEX), while others are European-style (SPX, NASDAQ). It's very important to know precisely when an option expires, and how it is settled.
Basically, settlement is what you get if you exercise an option. If an option is stock-settled, you will get a long position in the underlying stock if you exercise a call, or a short stock position if you exercise a put. U.S. equity options are stock-settled. If an option is cash-settled, you will get cash in the amount of the difference between the strike price of the option and the settlement value of the underlying index. The OEX and SPX index options are cash-settled.
When should you think about exercising a long equity option? When are you at risk of assignment if you are short an option? There is a specific economic rationale for exercising an equity option. Simply, is it cheaper to own the option, or to exercise the option? There are numerous academic treatises that discuss early-exercise, and reading them can be useful. But how an academic looks at early-exercise and how an option trader looks at early-exercise can be different.
For example, an academic evaluates whether he should exercise a long call based on how much it costs to hold the long position in stock that would result. How much interest would he have to pay to hold the stock for the time until the option would have expired? Are there any dividends payable? Their reasoning is very good, and not incorrect. From their point of view, the only time it is optimal to exercise an American-style call is immediately prior to the last ex-dividend date before expiration. That's because after the ex-dividend date the stock price falls by the dividend amount (which reduces the value of the call), and by exercising before the ex-dividend date, you can capture the dividend and reduce the cost of holding the stock. If a stock doesn't pay a dividend, you should never exercise a call before expiration.
It can be optimal to exercise an American-style put before expiration. It all has to do with the ability to collect any interest on the cash generated from shorting stock. Generally, it's best to exercise an in the money put immediately after the ex-dividend date, because the stock price will drop by the amount of the dividend (increasing the value of the put) and you won't owe that particular dividend if you become short the stock.
But an option trader adds one thing to the analysis. Is it cheaper to replicate a long call position by exercising the call and buying the put at the same strike price, or simply hold on to the long call? The trader knows that he can create a long call out of long stock and a long put. He also knows that no matter how ITM his long call is, it still has limited risk. If he exercises the call and becomes long stock, he is subject to unlimited risk.
So a trader will exercise an option if it's cheaper to replicate that option with stock and another option. How does this work?
Let's consider exercising a long call. If you exercise the call, you will buy stock at the strike price and your call disappears. Any extrinsic value the call had is lost. You have to pay the amount of the strike price as you take delivery of the stock. If you have to borrow money to buy the stock, you will pay interest. If you have enough cash to pay for the stock, you will stop earning any interest you were making on the cash. Either way, you will incur interest expense. Because you are now long stock, you are entitled to any dividends if you exercise the option before the ex-dividend date. Any dividends payable will offset the interest expense. But in order to have the same risk/reward profile you had with your long call, you have to buy the put of the same strike that the call had. So, you have to buy the put.
It can be seen, then, that it really wouldn't make sense to exercise a long call unless the dividend were so large that it offset all the interest expenses and the cost of the put.
For example, you are long 1 XYZ May 150 call expiring in 20 days and trading for $10.125. XYZ stock is at $160, and pays a dividend of $.15 and goes ex-dividend in 5 days. The XYZ May 150 put is trading for $.375. The interest rate to borrow money from your brokerage firm is 7%. What happens if you exercise the call?
You have to pay $15,000 for the stock ($150 * 100 shares). You will start paying interest of $2.92 per day, or $58.33 over the next 20 days. You will receive $15.00 from the dividend when it is paid (to be a real stickler, you should only count the present value of the dividend). The XYZ May 150 put costs $37.50.
So, you'll pay $58.33 for interest, $37.50 for the put, and receive $15.00 for the dividend. Netted out, it will cost $80.83 to replicate the long XYZ May 150 call with long XYZ stock and long the XYZ May 150 put. Also, you lose the $12.50 extrinsic value in the call. It wouldn't make sense to exercise the call in this case.
But what if XYZ paid a dividend of $1.50? In that case, you'll pay $58.33 for interest, $37.50 for the put, and receive $150 for the dividend. You also lose the $12.50 extrinsic value of the call, but netted out, you'll receive $41.67 to replicate the long XYZ May 150 call with long XYZ stock and long the XYZ May 150 put. It would make sense to exercise the call in this case.
Exercising a long put basically follows the same logic as exercising a long call, except that you would have to buy the call of the same strike as the put, pay dividends on the resulting short stock, and offset that with any interest received.
But consider the position of 100 shares of XYZ at $105 hedged with 1 XYZ Apr 100 put. The position is a synthetic long call, and if the price of XYZ starts falling, the losses will be limited. If XYZ falls below $100 per share, the XYZ Apr 100 put is in the money. If you believe that XYZ will continue to fall, and you want to exit the position you have a choice. You could exercise the put and deliver the XYZ shares at $100 or you could sell the XYZ Apr 100 call (and create a conversion). Which is better?
Think of it this way: if you exercise the put, you will be selling XYZ at $100, which generates $10,000 cash in your account. That cash will begin to earn interest. You would also forgo any dividends on XYZ stock. But if you sell the XYZ Apr 100 call, you will lock in any profit or loss on the long stock and put up to this point as if you sold the put and stock. The difference is that you may be able to sell the call at a high enough price to make more money than on the interest collected after selling the stock.
Let's say the time to expiration of the Apr XYZ options is 30 days and XYZ pays no dividend. The XYZ Apr 100 call is $0.625. The interest rate you could receive on cash is 6.00%. If you exercise the XYZ Apr 100 put, you will get $10,000 in your account, and will earn $50 in interest over 30 days. But if you sell the XYZ Apr 100 call at $0.625, you'll receive $62.50 in your account. At expiration, you will be out of the position whether the price of XYZ rises or falls, and you will make $12.50 more than if you had simply exercised the put.
So, there is an economic rationale for exercising an American-style option before its expiration. But you must be prepared to handle any margin issues that result. For example, for the XYZ May 175 put, you may have originally paid only $1.00 (or $100 total) for it. XYZ drops, and the value of the put rises to $15.25. If you exercise the put, you will be short XYZ stock at a price of $175. You will need to be able to handle the margin requirement of short $17,500 of stock. If you can't meet the margin requirement, your position may be liquidated.
A similar situation can occur with short ITM options. You must be alert to the possibility of being assigned on short ITM options, and the margin requirements that you might have to make. For example, if you are short one XYZ May 150 call, and XYZ stock is at $160, your short call may be assigned and you will be short 100 shares of XYZ at $150. You will have to meet the margin requirement for $15000 of short stock. A short put will leave you in the position of having to meet the margin requirement to purchase the stock.
Be aware also that when you exercise an option, you are giving up the limited risk characteristics of the option, for the unlimited risk characteristic of long or short stock.