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How do options exercise and assignment work? - YouTube
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[Music]
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if you're like most people
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you probably drive a car regularly yet
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you likely have no idea what's happening
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under the hood to make it run
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and that's how you might be feeling
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about exercising and being assigned on
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options
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you understand conceptually what these
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terms mean but how does the process
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actually work well that's what we're
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going to tackle here
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with some help from our options traders
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jack the buyer
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and sarah the seller let's say jack buys
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one call option for a fictional abc1
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corp stock
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at a strike price of 50 expiring in a
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month
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that gives him the right to purchase 100
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shares of the underlying stock
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at the strike price on or before the
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expiration date
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and on the other side let's say sarah
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sells that very same call
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she earns a premium on the sale of the
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option itself but in exchange
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she'll also be obligated to sell 100
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shares of the underlying stock
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at the strike price if she's assigned
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now let's imagine that abc1 corp stock
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climbs from 45 dollars per share
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to 55 putting jack's call in the money
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exercising the option would allow him to
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purchase the shares for fifty dollars a
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piece
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which is less than their market price of
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fifty five dollars
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he could then sell them for a profit of
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five dollars per share or five hundred
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dollars total
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minus the premium he paid as well as any
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fees and commissions of course
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or he could decide to hold him if he
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sees further upside ahead
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given this jack informs his broker that
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he'd like to exercise his option early
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to buy abc one stock at fifty dollars
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per share
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he also confirms that he has enough
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funds in his account to purchase the
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shares
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when that happens jack's broker sends an
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exercise notice to the central options
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clearing counterparty
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in canada that's the canadian
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derivatives clearing corporation
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owned by the montreal exchange in the
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united states
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it's the options clearing corporation
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that counterparty will then randomly
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assign a brokerage to handle the order
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why is this process random you ask well
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it's to ensure that there's a fair
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distribution of options assignments
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among the various clearing agents next
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the brokerage selected will dole out the
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assignment to clients that currently
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have a short position
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in that specific option in this case
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a call on abc1 corp at a 50 strike price
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with a one month expiry date if the
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exercise request is relatively small
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it may be assigned to a single client
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but larger requests could be divvied up
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among several
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this selection process must be approved
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by the options exchange
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upon which the contract trades also in
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the name of fairness
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of course the call buyer doesn't have to
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exercise all their contracts at once
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or at all but here jack only bought a
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single contract
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so just one trader who is short this
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specific option will be assigned
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and for simplicity's sake let's say it's
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sarah
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on the next trading day the broker will
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inform her that she's been assigned to
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fulfill the contract
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if sarah already owns 100 shares of abc1
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corp
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her broker will transfer them out of her
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account at a price of 50
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per share the shares are delivered to
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jack's broker
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who then places the shares into his
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account it takes two business days for
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them to settle
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however if sarah does not already own
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those 100 shares
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she'll be forced to short the stock
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immediately regardless of her account
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value
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or buying power jack will be charged an
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exercise
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fee and sarah an assignment fee by their
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brokers for this transaction
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if sarah ends up with a short position
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this could put her account into what's
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called
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a margin call that's when a margin
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account balance runs below the required
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minimum
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set by their broker sarah will need to
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either buy the shares back
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or deposit enough funds to sustain the
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short position
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this will bring her account back into
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good standing
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the settlement process is handled
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entirely by brokerages and works the
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same way for calls
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and puts in fact any option that is in
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the money by as little as one cent at
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expiry
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will automatically be exercised unless
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the buyer instructs their broker
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otherwise at td
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any do not exercise instructions must be
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provided no later
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than 4 30 pm eastern on the options
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final trading day
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most of the time though options won't be
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exercised
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it's common for traders to trade and
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close out their positions prior to
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expiration
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to avoid exercise or assignment but it's
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certainly a possibility
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and one that traders will want to be
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prepared for in case it happens
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those that are short the call option
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should be particularly cautious of early
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assignment
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if the underlying stock has an upcoming
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dividend especially if the dividend is
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higher than the extrinsic value
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left on the option in those cases the
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call owner may choose to exercise the
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option prior to its ex-dividend date
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in order to qualify for the dividend
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payout if that happens
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the short seller will need to deliver
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the shares and the dividend payment if
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the assignment leaves them with a short
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position
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at td direct investing you'll be able to
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see any exercise and assignment
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transactions the next morning
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under the activity page in web broker
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you should also take action immediately
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to bring your account back into good
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standing
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should a margin call occur now that you
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understand the mechanics of options
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exercise and assignment
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you can start thinking strategy and
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that's the perfect segue into the next
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series of lessons
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ways to use options
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[Music]
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