Option Basics: Exercise and Assignment
The Realities of Expiration, Parity, Early Exercise, and Assignment Risk.
In the previous chapter, Option Trading Procedures, we discussed how options are entered, closed, and managed in the marketplace. Those procedures govern the mechanics of trading—but eventually every option reaches a moment of truth: expiration. At that point, it is either exercised or it expires worthless—and for traders who are short options, assignment becomes very real. Understanding what actually happens at expiration, how parity factors into the process, and when early exercise can occur is essential. Without that knowledge, even experienced traders can be caught off guard. This chapter moves from trading procedure to expiration reality, explaining how exercise and assignment truly work—and dispelling several persistent myths along the way.
An option is said to have intrinsic value when the stock price is above the strike price of a call or below the strike price of a put. Another term that describes the situation where an option has intrinsic value is to say that the option is in-the-money. If the option has no intrinsic value, it is said to be out-of-the-money. For calls, this would mean that the underlying’s price is currently below the striking price of the call, and for puts it would mean that the underlying’s price is above the strike price of the put.
Another related definition that is important is that of parity. Any derivative security that is trading with no time value premium is said to be trading at parity. Sometimes parity is used as a sort of measuring stick. One may say that an option is trading at a half-point or a quarter-point above parity.
Example: XYZ is 53.
July 40 call: l2.75 = 1/4 point below parity
July 45 call: 8 = parity
July 50 call: 3.25 = 1/4 point above parity
Ultimately, one of two things happens to an option as it reaches expiration: it is exercised or it expires worthless. The owner (also called the holder) of an out-of-the-money option will let it expire worthless. This is any call where the stock, index, or futures price is below the strike price at expiration. In the same manner, he will let a put expire worthless if the underlying price is higher than the strike price at expiration. For example, if one owned the IBM July 50 call and IBM was trading at 45 at expiration, why would you want to exercise your call to buy 100 shares of IBM at 50 when you can just go to the stock market and buy 100 shares of IBM for 45? You wouldn’t, of course. Believe it or not, though, in the early days of option trading, things like that did happen occasionally.
In the movie, “Brewster’s Millions,” starring Richard Pryor, a minor league baseball player stands to inherit a large amount of money—something like $300 million—providing that he fulfill the terms of a rather crazy will: he must spend (or lose) something like $30 million in a short period of time. Of course, he goes through all kinds of crazy maneuvers to barely accomplish his appointed task by the given date. It’s an intriguing movie, as it gets you thinking about how much money you could spend quickly. I’ve often thought that he could have simplified his life considerably by just buying some options that were about to expire, whose strike price was way above the current market price, and exercising them. He could have squandered the $30 million in an instant!
Of course, if the option is in-the-money—that is, the price of the underlying is higher than the strike price of a call—then the owner of the call will exercise it because it has value. In an example similar to the previous one, if you own the IBM July 50 call and IBM is selling at 55,then you would exercise the call because you can buy IBM at 50 via your call exercise, whereas you would have to pay 55 to buy IBM in the open market. Conversely a put holder would exercise his put if it is in-the-money, that is, if the underlying’s current price were below the strike price, because the put gives him the right to sell at the higher price, the strike.
