Options related investing can be complex, especially compared to a basic buy-and-hold strategy. Because of this complexity, it is especially important to be precise in the words we choose to explain ourselves. But my observation over the years has been that clarity when a commentator on CNBC describes an options position he/she has taken is more often than not woefully inadequate. A typical example is a comment like "I sold some Calls on Amazon today." How frustrating! This comment gives us virtually no useful information, not even if the analyst is bullish or bearish on the stock.
At a minimum they should say whether (1) the Calls were established at-the-money, in-the-money, or out-of-the-money; and (2) whether they are Naked Calls, Covered Calls, or some form of options spread transaction being established in conjunction with existing options in the same stock.
Ideally they should say something like "Today I established an out-of-the-money Covered Calls position in Amazon at the $980 strike for the September 15th expiration. This will yield a 28% annualized return if assigned at expiration."
One area where I have noticed substantial confusion is the difference between the term 'exercise' and the term 'assignment'. To be honest, over the years I have often, incorrectly, used these two words interchangeably.
Whenever I seek clarity on the meaning of a particular investing-related concept, I first go to a wonderful site that is basically a dictionary of investing words and terminology -- investopedia.com.
Before reading the sentences about the terms '
exercise' and '
assignment' from Investopedia presented below, here is a basic background insight to help you distinguish the primary difference between these two terms:
- Exercising an option is done by the option buyer (i.e. the owner of the option).
- Assignment occurs to the option seller (as a direct result of the option buyer's exercise).
Explanations from Investopedia
In options trading, the buyer (or
holder) of a call contract may exercise his or her right to buy the underlying shares at the specified price (the strike price);
the buyer of a put contract may exercise his or her right to sell the
underlying shares at the agreed-upon price. If the buyer chooses to
exercise the option, he or she must inform the option seller (the
writer
of the option contract). This is achieved through an exercise notice,
the broker's notification that a client wishes to exercise his or her
right to buy or sell the underlying security. The exercise notice is forwarded to the option seller via the Options Clearing Corporation. Even though the buyer has the right but not the obligation to exercise the option, the seller
is obligated to fulfill the terms of the contract if the buyer decides to exercise the option.
"Assignment" is the designation by a clearinghouse of
an option writer who will be required to buy (in the case of a put) or
sell (in the case of a call) the underlying futures contract or security when an option has been exercised, especially if it has been exercised early.
How do these terms apply to Covered Calls?
Example #1: If we own a Covered Calls position where the stock price is in-the-money (stock price above the strike price) at market close on the options expiration date, then we are are '
assigned' so that we are required to sell the long stock position underlying the short Call options held. At this point, both the long stock and short Call options positions are liquidated to cash.
Example #2: Again, we own a Covered Calls position. We are short Call options. But remember, for every Call option sold, that same Call option has been bought by someone else. The Call option buyer (owner) has the right to sell his option on the open market at any time. But instead of simply selling his option, he/she can instead 'exercise' their Call option, meaning they have decided to buy the associated shares in the stock from someone who is short the same Call option. Note: a Call option owner is only incentivized to 'exercise' their option on either: (1) the day prior to an ex-dividend date; if the option is deep in-the-money so the time value remaining in the option is much less than the ex-dividend amount (for example, an ex-div of $.50 when the remaining time value is $.05 or less); or (2) only a few days prior to the options expiration date and the option is deep in-the-money such that the remaining time value in the option is very small (normally $.10 or less) relative to the price of the stock.
These two examples demonstrate what I mean in the first sentence above that: "Options related investing can be complex."
Here's a short mental exercise to check your own understanding of these two terms:
As we know, Covered Calls and Cash-Secured Puts are synthetically equivalent positions when done at the same strike price for the same expiration date. So, think through how the terms 'exercised' and 'assigned' are used when describing actions resulting from a short Cash-Secured Puts position.
Be patient in doing this because correct use of these two terms is definitely not easy to master.
I hope this blog post has been helpful. As always, your comments or questions are welcomed.
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Best Regards and Godspeed,
Jeff
