Market Basics

Overview

Writing options, which is also called selling options, alone or as part of a covered strategy, has unlimited risk potential in your account when writing a call option, and the maximum risk for writing a put is if the stock price goes to zero, which could cause a significant loss. As the writer of an option, you have certain obligations you must fulfill, and these obligations are out of your control while you maintain an open short options position.

When you write a call option, you take on the obligation to deliver long stock to the call buyer at the contract strike from the time of sale until the expiration date. For this obligation, you collect an option premium from the buyer at the current option price (less costs of the trade), which is your maximum gain on this position. The maximum risk here is unlimited, the stock can go to the moon, and you are on the hook for the entire journey.

When you write a put option, you take on the obligation to deliver short stock to the put buyer at the contract strike at any time from the time of sale until the expiration date. For this obligation, you collect an option premium from the buyer at the current option price (less the costs of the trade), which is your maximum gain on this position. The maximum risk here is unlimited for writing a call option, and when writing a put option the risk is limited to the stock going to zero, but this floor can still result in a significant loss.

Benefits of Writing Call and Put Options

Generally, writing options have two main benefits and purposes: (1) to capture the option premium time value as the option decays on the way to expiration; and (2) to reduce the cost of putting on a directional long call or put trade. Writing calls and puts and buying calls and puts in combinations allow you to trade many different market outlooks – bullish, bearish, low volatility, high volatility, and others.

The Risks of Writing Call and Put Options

First, most brokers require that you have some options trading experience before your account is approved to write options, and you will also be required to maintain a minimum account balance. You should always make sure that you have enough money to cover the initial margin and should consider an additional cushion amount for a reasonable move against the position and to deliver the stock position if assigned. Always check with your broker regarding minimum capital requirements.

Second, there is assignment risk throughout the life of the trade for American-style options. Typically, options are assigned only when they are deep in-the-money, or when there is an advantage to exercising to capture a stock dividend (see “Dividend Considerations” below). Still, an option writer can be assigned anytime up until expiration.

Finally, writing options generally requires a margin account, but you can also write a cash-secured put in a cash account that covers the full value of the options position.

Assignment Risk

You can never really tell when you will be assigned. Once you write an American-style option (put or call), you have the potential for assignment, to receive (and pay for) or deliver (and are paid for) shares of stock. In some circumstances, you may be assigned on a short options position while the underlying shares are halted for trading, or perhaps while they are the underlying company is the subject of a buyout or takeover.

To ensure fairness in the distribution of option assignments, the Options Clearing Corporation (OCC) utilizes a random procedure to assign exercise notices to clearing member accounts maintained with the OCC. The assigned firm must then use an exchange-approved method (usually a random process or the first-in, first-out method) to allocate notices to its clients’ accounts that are short the options.

Important Note

An option buyer holding a call or put has the right to exercise that option at any time to take delivery of the long (Call) or short stock (Put). The option writer is always at risk of early assignment at any time through expiration for American-style options.

There are several types of assignment risk factors you should understand:

1. In-the-money early exercise
   a. Dividend considerations
2. Exercise at expiration
   a. After-hours trading
   b. “Do not exercise”

In-The-Money Early Exercise

The chance of early assignment happens most often when the options are in-the-money (ITM), and although it is unlikely, even an option that is out-of-the-money (OTM), under certain circumstances, could be assigned at expiration.

Credit Spread early assignment example – in-the-money exercise
XYZ stock is currently trading at $80 per share. Two weeks ago, you put on a credit spread when XYZ was trading at $92 per share. You wrote 1 95 put for $5 and bought 1 90 put $2.50 for a credit of $2.50, or $250. Both options are now in-the-money, and the 95 put you wrote is assigned to you, and to offset that assignment, you exercise your 90 Put. You are flat, out of the position, but also incur a number of fees and may have some price risk before all is said and done.

Dividend Considerations

If you are writing a call option in a spread on a stock that pays a dividend, there is additional assignment risk if the call option is in-the-money and/or has less extrinsic (time value) than the dividend payout.

This is a good time to remind you that there can be a lot of moving pieces in an options trade. You should be aware of several factors if you are writing call options on a stock that pays a dividend including: the amount of the dividend, the ex-dividend date, and the impact the upcoming dividend payment may have on the price of the stock and the option premium.

If you are assigned short stock just prior to ex-dividend date, you will be responsible for paying the dividend. So, it may not be worth the trouble here. You may want to close or roll forward any short in-the-money call positions well in advance of any ex-dividend date.

Exercise at Expiration

At expiration, the buyer of an option is in control and can exercise at any time prior to the cutoff time on Friday expiration. If you hold short options, calls, or puts, into and through expiration, bad things could happen that are out of your control even if those options are out-of-the-money.

Keep in mind that most stock options stop trading at 4:00 pm ET when the regular stock market session closes, but many stocks continue to trade after hours until 8:00 pm ET, even on expiration Friday, which may affect the intrinsic value and possibly the decision of a call or put option buyer to exercise an option, as exercise can take place hours after the market has closed on expiration Friday.

Credit Spread after-hours assignment example at expiration – out-of-the-money exercise
It is expiration Friday, and the markets just closed. XYZ stock is currently trading at $96 per share. Two weeks ago, you put on a credit spread when XYZ was trading at $92 per share. You wrote 1 95 put for $5 and bought 1 90 put for $2.50, for a credit of $2.50, or $250. Both options expire out-of-the-money worthless, and you expect to collect your $250 profit. However, for some unknown reason, the buyer of a 95 put exercises, and you are selected and assigned the long stock. Your covering 90 put option has expired, leaving your new long stock exposed to the market, and over the weekend, the CEO of XYZ is arrested for embezzlement, and XYZ opens Monday at $50.00 per share, creating an unrealized loss in your account of $4,000 on that 1-contract position.

Do Not Exercise (DNE)

An option buyer may give his broker the instructions to “Do Not Exercise” at expiration regardless of the in-the-money value of the option. Why would someone just give away that money? Typically, this can happen when an option is slightly out-of-the-money at the close of the session on the expiration date, and there is a chance the option value will rise in the aftermarket session. Often, “Do Not Exercise“ instructions are given to the broker if the option buyer does not have enough money in their account to take delivery of the exercised stock.

“Do Not Exercise“ can be a problem for an option writer as the contract is voided. The voided contract is assigned to a random option seller of that contract.

Credit Spread assignment example at expiration – in-the-money – do not exercise
It is expiration Friday, and the markets just closed. XYZ stock is currently trading at $89.00 per share. Two weeks ago, you put on a credit spread when XYZ was trading at $92 per share. You wrote 1 95 put for $5 and bought 1 90 put for $2.50, for a credit of $2.50, or $250. Both options are now in-the-money, and you expect to lose $250 on the trade. However, a put buyer somewhere does not have enough money in his account to exercise their put option, so before the 5:30 pm deadline on expiration day, he informs his broker – “Do Not Exercise”; this will cause him to lose the $600 ($6 per share $95-$89). The OCC designates an options writer to offset this non-exercised put, and that contract is voided. However, you were counting on that short 95 put contract to offset your long 90 put, but there is now no short put any longer in your account, and you are auto-exercised on the long 90 put and must short the 100 shares of XYZ stock, and you are now exposed to the XYZ price action open on Monday.

Will I Get Assigned?

You can never really tell when you will be assigned. Once you write an American-style option (put or call), you have the potential for assignment, to receive (and pay for) or deliver (and are paid for) shares of stock. In some circumstances, you may be assigned on a short option position while the underlying shares are halted for trading, or perhaps while they are the subjects of a buyout or takeover.

To ensure fairness in the distribution of option assignments, the Options Clearing Corporation (OCC) utilizes a random procedure to assign exercise notices to clearing member accounts maintained with OCC. The assigned firm must then use an exchange-approved method (usually a random process or the first-in, first-out method) to allocate notices to its client’s accounts that are short the options.

Conclusion

Writing calls and puts even as part of a limited risk type spread can be high-risk strategies going into expiration and are not appropriate for every trader or every account.

And although the strategy of writing options is often to have the options expire worthless, you need to stay keenly aware of all the circumstances that can affect your position as it approaches expiration. There are a lot of moving pieces here, and you need to be aware of all of them.

So, based on all of the factors and risks, there may be times when closing a short options position prior to expiration, to avoid and assignment risk, may be the right call. It may cost you some profits, but it will reduce your stress and eliminate any further risk and the chance of an unexpected loss.