How to Avoid Option Assignment

Options contracts provide the right, but not the obligation, to buy or sell an underlying asset at a specific price by a certain date. Investors who sell, or “write,” options aim to profit from the premium received for taking on the obligation. Assignment occurs when an option buyer exercises their rights, obligating the seller to fulfill the contract. Avoiding assignment is often a key goal for option writers, as it can lead to unintended obligations. Understanding assignment mechanics and contributing factors is important for managing options positions.

Understanding Option Assignment

Option assignment occurs when the buyer of a short option exercises their contractual right, obligating the seller to fulfill the agreement. For a call option, the seller must deliver shares of the underlying stock at the strike price. For a put option, the seller must purchase shares at the strike price.

The Options Clearing Corporation (OCC) facilitates assignment, acting as the central clearinghouse for options transactions. When an option holder exercises, their broker submits an exercise notice to the OCC. The OCC then randomly allocates this assignment notice to brokerage firms holding short positions in that option series. After receiving the notice, the brokerage firm selects one of its customers holding the short option to be assigned, typically through a random selection process or a first-in, first-out (FIFO) method, depending on the firm’s policy.

Assignment is generally undesirable for option writers who aim to profit from time decay or volatility changes. It can trigger an unexpected obligation to either deliver or purchase the underlying asset, which may not align with the writer’s strategy. For example, an uncovered call writer who is assigned must acquire shares at market price to fulfill the delivery, potentially incurring significant costs. A put writer might be forced to buy shares at a price higher than the current market value.

Factors Leading to Assignment

In-the-Money (ITM) Options

Options that are deep in-the-money (ITM) are more likely to be exercised. An option is ITM if it holds intrinsic value: for a call, the stock price is above the strike; for a put, the stock price is below the strike. Buyers exercise ITM options to gain immediate intrinsic value.

Dividend Risk

For short call options, dividend risk is a factor. If a stock is about to pay a dividend and a call option is ITM, the buyer might exercise early to capture the dividend. This is more likely if the dividend amount exceeds the call option’s remaining extrinsic value.

Low Extrinsic Value

Options with very little or negative extrinsic value are also prone to assignment. Extrinsic value, or time value, is the premium beyond intrinsic value. As an option nears expiration, its extrinsic value diminishes rapidly. If it becomes negligible, buyers have less incentive to sell the option and more to exercise it, especially for ITM options.

Approaching Expiration

The closer an option gets to its expiration date, the higher the risk of assignment, particularly if it remains ITM. At expiration, if an option is ITM by even a minimal amount, the OCC typically exercises it automatically unless the holder instructs otherwise. This automatic exercise leads directly to assignment.

Illiquid Options

Illiquid options can contribute to unexpected assignment scenarios. Wide bid-ask spreads in illiquid markets can make it difficult for an option writer to close a position efficiently, potentially trapping them in a situation where assignment becomes unavoidable.

Practical Strategies to Avoid Assignment

Option writers can employ several strategies to mitigate or prevent assignment as market conditions evolve or expiration approaches.

Close the Position

The most direct method is to close the short option position before it is exercised. This involves buying back the option in the open market, canceling the obligation. Closing the position allows the writer to lock in profits or limit losses, eliminating assignment risk.

Roll the Position

Rolling involves simultaneously closing the existing short option and opening a new short option, often with a later expiration date, a different strike price, or both. Rolling “out” to a later expiration provides more time for the underlying asset’s price to move favorably. Rolling “up” or “down” to a different strike can adjust the risk profile or collect additional premium, delaying or avoiding assignment.

Exercise a Long Option

For writers in a spread strategy or holding a hedged position, exercising a corresponding long option can fulfill an assignment obligation. If the short leg of a spread is assigned, an offsetting long option can be exercised to acquire or deliver the necessary shares. This helps manage the resulting stock position and prevent the need for an unplanned purchase or sale of shares in the open market.

Manage Around Ex-Dividend Dates

Call writers should manage positions carefully around ex-dividend dates to avoid early assignment. Option buyers might exercise ITM call options early to capture a dividend. To avoid being assigned shares and owing the dividend, a call writer can close the position before the ex-dividend date. Alternatively, they might roll the call option to a later expiration or a higher strike price.

Monitor In-the-Money Options

Continuous monitoring of in-the-money short options, especially as they approach expiration, is important. As expiration nears, assignment probability for ITM options increases due to rapid extrinsic value decay. Writers should be prepared to take action before market close on expiration day if their short options are ITM, either by closing or rolling the position.

Establish Mental Stop-Loss Levels

While not a direct avoidance method, establishing mental stop-loss levels prompts a trader to close a position before assignment risk becomes too high. This involves pre-determining a price point at which the option position will be closed to prevent further losses or an undesirable assignment. Although physical stop-loss orders are not always practical for options, a disciplined approach to closing positions when certain criteria are met can help manage assignment risk effectively, preventing the financial and logistical complexities that often accompany an unexpected assignment.