Understanding assignment risk in Level 3 and 4 options strategies

E*TRADE from Morgan Stanley

10/20/20

With all options strategies that contain a short option position, an investor or trader needs to keep in mind the consequences of having that option assigned, either at expiration or early (i.e., prior to expiration). Remember that, in principle, with American-style options a short position can be assigned to you at any time. On this page, we’ll run through the results and possible responses for various scenarios where a trader may be left with a short position following an assignment.

Before we look at specifics, here’s an important note about risk related to out-of-the-money options: Normally, you would not receive an assignment on an option that expires out of the money. However, even if a short position appears to be out of the money, it might still be assigned to you if the stock were to move against you just prior to expiration or in extended aftermarket or weekend trading hours. The only way to eliminate this risk is to buy-to-close the short option.

Another important note: In any case where you close out an options position, the standard contract fee (commission) will be charged unless the trade qualifies for the E*TRADE Dime Buyback Program. There is no contract fee or commission when an option is assigned to you.

 

Short (naked) call

If it's in-the-money at expiration If it's out-of-the-money at expiration

The option will be automatically assigned to you.

This means your account must be able to deliver shares of the underlying—i.e., sell them at the strike price. If your account doesn't have the buying power to cover the sale of shares, you may receive a margin call.

Actions you can take: If you don’t want to sell your shares or you don’t own any, you can buy the call option before it expires, closing out the position and eliminating the risk of assignment.

The option expires worthless, and no action is required from you.

If you experience an early assignment

An early assignment is most likely to happen if the call option is deep in the money and the stock’s ex-dividend date is close to the option expiration date.

If your account does not hold the shares needed to cover the obligation, an early assignment would create a short stock position in your account. This may incur borrowing fees and make you responsible for any dividend payments.

Also note that if you hold a short call on a stock that has a dividend payment coming in the near future, you may be responsible for paying the dividend even if you close the position before it expires.

Naked put

If it's in-the-money at expiration If it's out-of-the-money at expiration

The option will be automatically assigned to you.

This means your account must have enough money to buy the shares of the underlying at the strike price or you may incur a margin call.

Actions you can take: If you don’t have the money to pay for the shares, you can buy the put option before it expires, closing out the position and eliminating the risk of assignment and the risk of a margin call.

The option expires worthless, and no action is required from you.

If you experience an early assignment

An early assignment generally happens when the put option is deep in the money and the underlying stock does not have an ex-dividend date between the current time and the expiration of the option.

Credit call spreads

Short call + long call

(The same principles apply to both two-leg and four-leg strategies)

If the short leg is in-the-money and the long leg is out-of-the-money at expiration

The short leg will be automatically assigned, and the long leg will expire worthless.

This means your account will deliver shares of the underlying—i.e., sell them at the strike price.

Actions you can take:

If you don’t have the shares to sell, or don’t want to establish a short stock position, you can buy the short call before expiration, closing out the position.

If the short leg is closed before expiration, the long leg may also be closed, but it will likely not have any value and can expire worthless.

If you experience an early assignment

This would leave your account short the shares you’ve been assigned, but the risk of the position would not change. The long call still functions to cover the short share position. Typically, you would buy shares to cover the short and simultaneously sell the long leg of the spread.

Pay attention to short in-the-money call legs on the day prior to the stock’s ex-dividend date, because an assignment that evening would put you in a short stock position where you are responsible for paying the dividend. If there’s a risk of early assignment, consider closing the spread.

Credit put spreads

Short put + long put

(The same principles apply to both two-leg and four-leg strategies)

If the short leg is in-the-money and the long leg is out-of-the-money at expiration

The short leg will be automatically assigned, and the long leg will expire worthless.

This means your account will buy shares of the underlying at the strike price.

Actions you can take:

If you don’t have the money to pay for the shares, or don’t want to, you can buy the put option before it expires, closing out the position and eliminating the risk of assignment.

Once the short leg is closed, you can try to sell the long leg if it has any value, or let it expire worthless if it doesn’t.

If you experience an early assignment

Early assignment would leave your account long the shares you’ve been assigned. If your account does not have enough buying power to purchase the shares when they are assigned, this may create a Fed call in your account.

However, the long put still functions to cover the position because it gives you the right to sell shares at the long put strike price. Typically, you would sell the shares in the market and close out the long put simultaneously.

Debit call spreads

Long call + short call

(The same principles apply to both two-leg and four-leg strategies)

If the long leg is in-the-money and the short leg is out-of-the-money at expiration

The long leg will be automatically exercised, and the short leg will expire worthless.

This means your account will buy shares at the long call’s strike price.

Actions you can take:

If you don’t have enough money in your account to pay for the shares, or you don’t want to, you can simply sell the long call option before it expires, closing out the position.

However, unless you are approved for Level 4 options trading, you must close out the short leg first (or simultaneously). The easiest way to do this is to use the spread order ticket to buy to close the short leg and sell to close the long leg.

Assuming the short leg is worth less than $0.10, the E*TRADE Dime Buyback program would apply, and you’ll pay no commission to close that leg.1

If you experience an early assignment

Debit spreads have the same early assignment risk as credit spreads only if the short leg is in-the-money.

An early assignment would leave your account short the shares you’ve been assigned, but the risk of the position would not change. The long call still functions to cover the short share position. Typically, you would buy shares to cover the short share position and simultaneously sell the remaining long leg of the spread.

Pay attention to short in-the-money call legs on the day prior to the stock’s ex-dividend date, because an assignment that evening would put you in a short stock position where you are responsible for paying the dividend. If there’s a risk of early assignment, consider closing the spread.

Debit put spreads

Long put + short put

(The same principles apply to both two-leg and four-leg strategies)

If the long leg is in-the-money and the short leg is out-of-the-money at expiration

The long leg will be automatically exercised, and the short leg will expire worthless.

This means your account will buy shares at the long call’s strike price.

Actions you can take:

If you don’t have the shares, the automatic exercise would create a short position in your account. To avoid this, you can simply sell the put option before it expires, closing out the position.

However, you may not have the buying power to close out the long leg unless you close out the short leg first (or simultaneously). The easiest way to do this is to use the spread order ticket to buy to close the short leg and sell to close the long leg.

Assuming the short leg is worth less than $0.10, the E*TRADE Dime Buyback program would apply, and you’ll pay no commission to close that leg.1

If you experience an early assignment

Debit spreads have the same early assignment risk as credit spreads only if the short leg is in-the-money.

An early assignment would leave your account long the shares you’ve been assigned. If your account does not have enough buying power to purchase the shares when they are assigned, this may create a Fed call in your account.

However, the long put still functions to cover the position because it gives you the right to sell shares at the long put strike price. Typically, you would sell the shares in the market and close out the long put simultaneously.

All spreads that have a short leg

(when all legs are in-the-money or all are out-of-the-money)

If all legs are in-the-money at expiration If all legs are out-of-the-money at expiration

The long leg(s) will be automatically exercised, and the short leg(s) will be automatically assigned.

For call spreads, this will buy shares at the long call’s strike price and sell shares at the short call’s strike price.

For put spreads, this will sell shares at the long put strike price and buy shares at the short put strike price.

In either case, this will happen in the account after expiration, usually overnight, and is called same-day substitution.

Your account does not need to have money available to buy shares for the long call or short put because the sale of shares from the short call or long put will cover the cost. There will be no Fed call or margin call.

The option expires worthless, and no action is required from you.

If you experience an early assignment

Calls:

This would leave your account short the shares you’ve been assigned, but the risk of the position would not change. The long call still functions to cover the short share position. Typically, you would buy shares to cover the short and simultaneously sell the long leg of the spread.

Pay attention to short in-the-money call legs on the day prior to the stock’s ex-dividend date because an assignment that evening would put you in a short stock position where you are responsible for paying the dividend. If there’s a risk of early assignment, consider closing the spread.

Puts:

Early assignment would leave your account long the shares you’ve been assigned. If your account does not have enough buying power to purchase the shares when they are assigned, this may create a Fed call in your account.

However, the long put still functions to cover the long stock position because it gives you the right to sell shares at the long put strike price. Typically, you would sell the shares in the market and close out the long put simultaneously. 

 

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