What is the options assignment risk?
Trading options is a very lucrative way to make money in the stock market. Using the same methods that I teach in my trading PowerX Trading Strategy, I was able to turn a 25k account into a 45k account in 2 months!
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25K to 45K in 2 months? This sounds too good to be true… and I would like to tell you that it is NOT too good to be true, but there are some inherent risks associated with options trading.
ONE of the biggest risks, and possibly the MOST common risk associated with trading options are options assignment risks.
As you may know by now, options contracts expire. When you purchase an options contract you have the right to exercise the contract, and buy or sell the underlying asset for the agreed-upon price. If you allow the contract to expire in the money (ITM) you run the risk of being assigned the 100 shares of the underlying stock.
This is known as an options assignment risk.
Specific Examples of Options With Different Expiration Dates
In the example we’re going to discuss today, we’re going to look at how options expiration or the length of time to expiration can affect your options assignment risk.
To illustrate the relationship between options assignment risk and options expiration, we’re going to look at trading a 315 call options contract on Apple (AAPL) with 7 days left until expiration. The current strike price of AAPL is 318.
This options contract is currently trading for $6, but only has $3 of intrinsic value. If you were to exercise the option, you would be able to purchase the AAPL stock for $315, and you would capture $3 of profit. If you sell the option, you’ll earn twice that, because the options contract is selling for $6.
The difference in the cost of the intrinsic value ($3) of the option and actual value ($6) of the option has to do with time decay. As the option contract gets closer to its expiration date, time decay erodes the value of the options contract.
In our next example, we’ll look at trading the same options contract with a $315 strike price, but with 0 days to expiration.
As you can see in this image, the same contract with zero days until expiration has only $3 of value. Time decay, otherwise known as theta, has slowly eaten away the value of the contract so that now there is only the intrinsic value of the option left.
As an options contract nears expiration, the risk of options assignment increases exponentially. When an options contract has been purchased, it can usually be sold before expiration to prevent an assignment.
However, options contracts that have been sold pose the opposite risk. If you have sold a put contract for example, and the options contract is in the money at expiration, you must either buy back the contract BEFORE expiration, or risk options assignment.
In this next example, we will look at selling a put contract on Herts (HTZ).
The current price strike price of HTZ is $2.87.
If you were to SELL a $3 put option on HTZ, the option would have the intrinsic value of .13 cents! Meaning if you chose to exercise the option, you would only make .13 cents per share.
If we look at this option with 1 week out until expiration we can see that it has more value because time decay has not eroded the value.
In the image of the HTZ option chain above we can see that the $3 dollar put option with one week until expiration has .85 cents of value.
To Exercise or to Sell, That Is The Question
As you can see, there’s WAY more profit when selling a contract vs exercising a contract when there is time to expiration.
In summary, it’s very unlikely that someone will exercise an options contract when there is time remaining before expiration. There is usually more profitability when there is less time decay or Theta decay in the contract.
When should you worry about options assignment risk?
Some traders are under the impression that IF the stock price moves below or above your strike price (depending on whether you sold a put or call) you risk assignment immediately. This is NOT true. You risk assignment the closer your contract gets to expiration.
Trading Futures, options on futures and retail off-exchange foreign currency transactions involves substantial risk of loss and is not suitable for all investors. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources. You may lose all or more of your initial investment. The lower the day trade margin, the higher the leverage and riskier the trade. Leverage can work for you as well as against you; it magnifies gains as well as losses. Past performance is not necessarily indicative of future results.