In options trading (American style), the options contract owner (or buyer) has the right to exercise the options contract anytime between the start of the contract and the expiration date. An early assignment means the options contract buyer chooses to exercise the contract before the expiration date.
However, it is usually rare as there is a time value as part of the premium that he has paid for when the options contract was established. An early assignment would mean that he would forgo some of the premium he had paid when the contract was established.
Who Is At Risk Of Early Assignment?
However, there are a few scenarios where early assignment (exercise) of a contract may happen and it is important for the options seller to take note of them, especially if he has no intention to buy (PUT contract) or sell (CALL contract) his shares. The risk applies to the options contract sellers because only the options buyer has the right to exercise the contract anytime before the expiration date.
The PUT options seller may just want to collect a premium through selling a PUT options contract and has no intention of owning the shares. Thus, he would hope that the PUT options contract that he sold would expire worthless instead of expiring In-The-Money (ITM).
I am in this group when I use the SOP strategy to collect monthly income through selling OTM PUT options contracts:
My Options Trading Strategy For 2023 | Introducing SOP Options Trading Strategy
In another scenario, the PUT seller may not have enough capital to purchase the shares, which means it is not a cash-secured PUT, where the seller has set aside capital to purchase the shares if he gets assigned the contract.
This is possible with a margins account:
How I Use My Margins Account To Earn Extra Income (Safely)? | How My Margins Account Help In My Selling PUT Strategy?
In another group of CALL options sellers who are at risk, the seller may not wish to sell away his shares at the strike price, which he could have set much lower than his breakeven pricing. It may also be a naked short CALL, whereby the seller may not have the shares to honor the contract if it gets assigned early.
What Are The Possible Scenarios Of Early Assignment?
The risk of assignment for the CALL options contract sellers increases when the underlying stock pays dividends and when it is nearing the ex-dividend date. The CALL options contract buyers are not entitled to dividend payments, so if they wish to receive the dividend, they will have to exercise the CALL options and become stock owners.
If the upcoming dividend amount is larger than the time value remaining in the call’s price, it makes sense to exercise the option contract. But the CALL buyers will have to exercise the options contract prior to the ex-dividend date.
So for CALL options sellers who do not wish to get assigned, always be mindful if you are selling a stock that is paying dividends, and do take note if the ex-dividend date is close to the expiration date, the call options contract is in-the-money, and the dividend is relatively large. All these scenarios will significantly increase the chance of early assignment.
For PUT options contract sellers, the risk will increase in the scenario whereby the buyer is in an advantageous position and wishes to sell away his shares to collect the cash. However, he must factor the time value into the equation, before deciding if it is indeed a wise decision to exercise the PUT options early.
For PUT options contract buyers, it is usually a good idea to sell the put first and then immediately sell the stock. That way, he can capture the time value for the put along with the value of the stock. However, as expiration approaches and time value becomes negligible, early exercise seems plausible. That’s because by exercising the PUT contract, the PUT buyer can accomplish his aim of selling the shares and collecting the capital, all in one simple transaction without any further hassles or extra commission charges.
Therefore, for PUT options contract sellers, remember that the less time value there is in the price of the option as the expiration date nears, the higher the risk of an early assignment. So keep a close eye on the time value left in your short puts and have a plan in place in case you’re assigned early.
For PUT options contract sellers, an approaching ex-dividend date can be a deterrent against early exercise for PUT. By an early assignment, the options contract buyer will receive the cash now. However, this will create a short sale of stock if the PUT owner wasn’t owning the stock in the first place. So exercising the PUT options the day before an ex-dividend date means the PUT buyer will have to pay the dividend. So, this means PUT sellers may have a lower chance of being assigned early, but only until the ex-dividend date has passed.
Concluding Thoughts
To summarise, an options contract buyer (owner) will exercise early if certain conditions are met to ensure that what he receives is more than enough to cover the remaining time value in the contract (which he has already paid upfront when the contract was established).
For CALL buyers, it would be the dividends paid out, that are greater than the remaining time value. For PUT buyers, it would be the increase in premium (due to the underlying share price moving in the intended direction, i.e. stock price collapsing) being greater than the remaining time value in the contract.
In a nutshell, as the difference between the intrinsic value (the difference between the current price of a stock and the strike price of the option) and the extrinsic value (the difference between the market price of an option and its intrinsic value) increases, the risk of early assignment also increases. So, to manage the risk of early assignment, the options seller must be mindful of the increasing intrinsic value and the decreasing extrinsic value.
To mitigate against early assignment, the options contract seller can prolong the contract duration by rolling it to a later date and collecting more upfront premiums in the process. This also increases the extrinsic value of the options contract. Alternatively, he can also avoid selling CALL options on stocks that pay dividends or with an expiration date close to the ex-dividend date.
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