Why does assignment risk matter in options trading?

Assignment risk refers to the possibility that an options contract you have sold (either a call or a put) will be exercised by the holder before or at expiration, requiring you to

Assignment risk is a crucial consideration for anyone who sells options, whether they are call options or put options. When you sell an option, you are taking on an obligation: for a call option, it's the obligation to sell the underlying asset at the strike price if assigned; for a put option, it's the obligation to buy the underlying asset at the strike price if assigned. Assignment risk is the chance that the buyer of the option will choose to exercise their right to buy or sell the underlying asset from or to you. While European-style options can only be exercised at expiration, American-style options can be exercised at any point up to and including expiration. This means for American-style options, assignment can occur unexpectedly, even if the option is not deeply in the money. The decision by an option holder to exercise is often driven by factors such as dividends, interest rates, and whether the option is in the money. For example, a call option holder might exercise early to capture an upcoming dividend if the call is deep in the money. Similarly, a put option holder might exercise if the stock has fallen significantly below the strike price. Being assigned means you are obligated to take a specific action, which could lead to an unwanted long or short position in the underlying asset, or the need to deliver shares you don't own (requiring you to buy them at market price). This can result in significant market exposure and potential losses if the market moves against your new position, or if you are forced to cover. Managing assignment risk requires careful monitoring of options positions and understanding the factors that prompt early exercise.

Why it matters

- Assignment risk can lead to unexpected obligations. If you sell a call option and are assigned, you must sell the underlying shares. If you don't own them, you will have to buy them at the current market price, potentially at a loss if the stock has risen significantly.
It can result in a change in your portfolio's exposure. Being assigned on a put option, for instance, means you are obligated to buy shares, transforming a short options position into a long stock position, which changes your market exposure and risk profile.
Assignment may occur at an inconvenient time or price. Given that American-style options can be exercised at any time, an option seller faces the possibility of being assigned when they least expect it, or at a strike price that is unfavorable compared to the current market value, impacting profitability and requiring immediate action.
Understanding assignment risk is crucial for risk management and strategy selection. By knowing when and why assignment might occur, traders can implement strategies like rolling positions, closing options before significant risk arises, or choosing European-style options where applicable, to mitigate potential negative impacts.

Common mistakes

- Ignoring the possibility of early exercise for American-style options. Many traders incorrectly assume assignment only happens at expiration, leading to surprise assignments, especially around dividend dates for call options or significant price drops for put options. Always be aware that American-style options can be exercised at any time.
Not monitoring options that are slightly in the money or approaching in-the-money status. Options that are near or slightly in the money carry a higher assignment risk as they become more attractive for holders to exercise, often due to dividends or interest rate differentials. Regularly check the intrinsic value of your sold options.
Failing to have a plan for assignment. What will you do if you are assigned? Do you have the capital to fulfill your obligation, or shares to deliver? Without a pre-determined strategy, you might be forced into hasty decisions that are not optimal, or incur unexpected transaction costs and market exposure.
Overlooking the costs associated with assignment. Besides the potential loss on the underlying asset, there can be transaction fees for exercising and potentially margin calls if your new position in the underlying asset exceeds your account's buying power. Factor these potential costs into your risk assessment.

FAQs

What triggers assignment risk for an option seller?

Assignment risk is triggered when the holder of an option decides to exercise their right to buy or sell the underlying asset. For American-style options, this can happen at any time if the option is in the money, often driven by factors such as an upcoming dividend for calls or a significant price move for puts.

Can I avoid assignment risk entirely when selling options?

While you cannot entirely eliminate assignment risk for American-style options you sell, you can manage and mitigate it. Strategies include choosing European-style options if available, closing out positions before they become deep in the money, or rolling positions to different strike prices or expiration dates to avoid immediate assignment.

What happens financially if I get assigned on a call option I sold?

If you are assigned on a call option you sold, you are obligated to sell the underlying shares at the strike price. If you already own the shares (covered call), they will be called away. If you don't own them (naked call), you will be forced to buy them at the current market price and then sell them at the strike price, potentially incurring a significant loss if the market price has risen above the strike.