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Understanding Option Exercise and Assignment

Exercise and Assignment

When a stock option is exercised, the call holder buys the stock, and the put holder sells the stock. When options are exercised, the OCC decides to which brokerage firm the exercise will be assigned, and the brokerage in turn decides which customer will get the assignment. When we are assigned an exercise and are required to sell our shares, the shares sold are said to have been called out or called away. Assignment occurs, then the shares are called out. Assignment on a short puts means purchasing the stock.

Assignment is completely random, and an exercise can be assigned to and appointed among several different call writers. Once assignment by OCC occurs, settlement between the buying and selling parties is automatic. Shares must be physically delivered once exercise occurs. The covered call writer doesn’t have to do anything; the call writer’s broker handles settlement, delivers the shares and collects the exercise funds. Option exercise or assignment can be partial: one can exercise less than all options held. Conversely, you may be assigned on less than all of your short calls or puts. However, one cannot exercise or be assigned on part of a single option contract. If you buy a call (put), you are not required to buy (sell) the underlying stock: you may sell the option to close or allow it to expire worthless.

Automatic Exercise

The OCC automatically exercises options that are $0.01 or more ITM, unless the option holder has notified their broker not to allow exercise of the option. Note that a stock’s price can tick up or down after the close on expiration Friday, resulting in calls or puts (but not both calls and puts) that were near the money at Friday’s close becoming in the money – and being exercised.

If you are long calls on expiration Friday, you could find yourself purchasing shares unexpectedly, due to a late-day or after market tick up in the stock. Or if instead long the puts, then, you might find yourself selling shares unexpectedly: and if you don’t own the underlying shares, this would either create a short stock position in your account, or your broker would buy you in (purchase the shares on your behalf) in order to cover itself. Be sure your broker knows your intention if you are long options at expiration and have nor closed them. Writers of short calls and puts can similarly find themselves assigned an exercise due to the same mechanism.

Early Exercise

Because stock options are American-style, you can be assigned as exercise any time an option is in the money, although options typically are not exercised early while there is still time value remaining. The reason is that the exercise of an option forfeits its time value; to capture the time value it is necessary to flip (sell) the option. But as expiration draws near, options that are in the money sometimes trade at parity, and this is when early exercise occurs. Options trading below parity practically beg arbitrageurs to exercise them for risk-less profit.

Where Stock Options Go

Option traders say that only 10% of options are exercised, which is generally true but not in all cases. Thus if you write a call, the odds against assignment are roughly 9:1, statistically speaking. But if a call is written ITM, the odds are quite high it will be exercised, despite the overall 9:1 odds. No matter where written originally, if the calls are in the money $0.01 or more at expiration, exercise is a virtual certainty. ATM and OTM options are never exercised, since it is cheaper to buy or sell stock in the open market than to exercise an option.

You have probably heard option seller’s state they are right 90% of the trades. This is due to only 10% or so being assigned. There is more to this story as we continue this journey.

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Covered Calls for Life

How do you measure the financial health of a business or public company? They are measured by the amount of cash flow they produce. All investors understand this concept as this leads to the earnings reported and financial strength of the company. Covered call investing provides a large amount of cash flow.

There are several styles of covered call writing. Some investors never do more than write calls on their portfolio stocks that can be an art within itself. Many investors buy stocks for the express purpose of writing covered calls on them and then sell the stocks or let them be called away at expiration. There are covered call strategies for the active trader who seeks action, for the shoot for the moon directional trader, for the lazy writer and for those with a long-tern horizon. Then the conservative crowd are fearful of risk and seeking low-risk or limited-risk trades.

As an investor, you can have covered call your way. No matter your lifestyle, if you have a computer or smart phone, there is a covered call strategy that will work for you. Is it riskless? No – but there are ways to lower your risk in the trade like insuring the trade.

If you are an investor interested in creating income streams. Then, covered call writing should be part of your portfolio.  You can write calls against your dividend stocks to enhance your income. I like to think about covered call writing as a monthly income stream.

I can sell a call option each month on a stock I own. This premium income is automatically deposited into my account at the transaction completion. Now, do this every month for a year. Then, add up the amount of the premium income for the 12 months and divide it by the purchase price of the stock. Compare this calculated covered call yield to the stock dividend yield. Which is higher? Typically, the stock dividend yield may be 3-5% but the covered call yield will be 15-20% yield.

For an income investor, a call yield this high is a great stream of income and it provides some downside price protection. Using the “rule of 72” will result in doubling your investment in 3.5 years. Even better, you can add $1,000s of income each month to a medium size portfolio.

The theory of covered call writing explained here should catch the eye of the income investor. This clearly shows why covered call should be a lifestyle-making portion of your investments. We like to say Covered Calls for Life is where it is at for multiple streams of income.

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