Mastering Exercise and Assignment of Options

In the financial world, options are a type of derivative security whose value depends on that of an underlying asset. Understanding how options work, particularly the processes of exercising and assignment, is crucial whether you’re an investor aiming to pass the FINRA Securities Industry Essentials® (SIE®) Exam or an active participant in the securities markets. This chapter provides detailed explanations and real-world examples to help you grasp these concepts thoroughly.

Understanding Options

Definition

An option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, within a specified period. The buyer pays a premium to the seller (option writer) for this right.

Types of Options

• Call Option: Grants the holder the right to buy the underlying asset.
• Put Option: Grants the holder the right to sell the underlying asset.

The Process of Exercising Options

Exercise Defined

Exercising an option means implementing the right to buy (in the case of a call) or sell (in the case of a put) the underlying asset at the agreed-upon strike price.

• Call Option Example: If you’re holding a call option for Company XYZ stock with a $50 strike price, and the stock’s market price reaches $60, exercising the option allows you to buy the stock for $50.

• Put Option Example: Conversely, if you have a put option on Company ABC stock with a $40 strike price and the stock’s market price falls to $30, you can sell the stock for $40 by exercising the option.

When to Exercise

Options can be in, at, or out of the money, which influences the decision to exercise:

• In the Money (ITM): The option has intrinsic value.
• At the Money (ATM): The option’s strike price is equal to the underlying asset’s current price.
• Out of the Money (OTM): The option lacks intrinsic value, making it unprofitable to exercise.

Visual Aid

    graph TD;
	  A[Options] --> B[Call Option]
	  A --> C[Put Option]
	  B --> D[Exercising Call]
	  C --> E[Exercising Put]

Assignment and Obligations of Option Writers

Assignment Defined

Assignment occurs when an option writer is compelled to fulfill the contract terms. For the writer of a call option, this means selling the asset; for a put option writer, it means buying the asset.

Obligations of Writers

• Call Writers: Must deliver the underlying asset at the strike price if the option is exercised.
• Put Writers: Must purchase the underlying asset at the strike price if the option is exercised.

Risk Factors

• Unlimited Loss for Call Writers: If the underlying asset’s price climbs significantly, the loss potential can be immense because the writer must deliver the asset at a much-lower strike price.
• Substantial Loss for Put Writers: If the asset’s price plummets, they are obligated to purchase at a higher-than-market price.

Example Scenario

Imagine writing a put option on 100 shares of Company DEF with a strike price of $50. If these shares drop to $30 and the option is exercised, you’re obliged to buy the shares at $50, resulting in a loss of $20 per share.

Summary Points

• Exercise Process: Understand when and why an option holder might exercise their rights.
• Assignment Risks: Be aware of your obligations as an option writer.
• Evaluation: Regularly assess the market conditions and intrinsic value of options.

Glossary

• Premium: The price paid for the option.
• Strike Price: The predetermined price of the underlying asset in the contract.
• Intrinsic Value: The actual value of the option, calculated by the difference between the underlying asset’s price and the strike price.

Additional Resources

• Books: “Options as a Strategic Investment” by Lawrence G. McMillan.
• Websites: Investopedia - Options Basics.
• Online Courses: Khan Academy Finance & Capital Markets.