Buying and selling stock is the most common way for investors to benefit from a company’s success, but it isn’t the only way.
Experienced traders know it is possible to turn a profit, even when the selected company’s shares lose value. Purchasing options to buy (call) or sell (put) shares in the future at a pre-determined price comes with risk – but when the bet pays off, there may be substantial rewards.
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Option Assignment: The Basics
An options transaction begins with a contract. The writer of the contract agrees to buy or sell shares at an agreed-upon price, known as the strike price, within a specified timeframe.
In the US, the holder of the contract can exercise the option to buy or sell stock at the strike price any time, up to and including the contract’s expiration date. European options can only be exercised on the on the contract’s expiration date.
Options contracts are typically written in 100 share increments, so if the premium fee is $0.30 per share, one option (100 shares) would cost the contract holder $30.
Investors who hold options contracts are not required to exercise them. If they choose not to, they lose the per-share premium fee paid for the contract.
Risks & Benefits Of Options
Investors who believe that stock prices will increase can purchase options to buy shares at a specific price.
If share prices go up as expected, the contract holder has an opportunity to purchase them at the agreed upon rate, which is lower than market value. The contract itself can also be sold to other investors who want the option to buy at the option price.
Investors who believe share prices will decrease can purchase options to sell (or put) the shares to the contract writer.
Assuming the stock price does, in fact, go down, the contract holder profits by selling shares for more than market value.
Alternatively, if the contract holder does not already own the shares, it is possible to sell the contract itself. It has value to other investors who own the shares and want to reduce their losses when the value drops.
Assigning options is the process through which options buyers exercise their rights to buy or sell stock at the price agreed upon in the option contract. The transaction is “assigned” or matched to a contract writer, and the contract writer must meet the terms of the option agreement.
While the option contract buyer is not required to exercise options, the option contract writer is obligated to meet the conditions outlined in the agreement.
Short Call Option Assignment
Investors with options to buy shares at a pre-determined strike price own call options. They can buy or “call” shares away from the contract writer if they choose to exercise their options.
Call Option Assignment Example
Shares of XYZ Co. are currently selling at $50 per share. You believe the price will increase to $60 per share within a month. You purchase an option that allows you to buy 100 shares at $55 within the next month. This costs you $0.25 per share, for a total of $25.
If the share price doesn’t go above the strike price before your option expires, your loss is $25. However, if it does rise beyond $55, your option is “in the money”.
Say share prices increase to $58, and you choose to exercise your options. The transaction is automatically assigned to an option contract writer, and you have an opportunity to call or buy 100 shares of XYZ Co. from that writer at $55 per share.
Your profit is $3 per share or $300 (for every 1 call contract purchased), less the $25 premium and any transaction fees. To lower your transaction costs, consider tastyworks which charges $0 commissions on closing stock and options trades (*clearing fees still apply).
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Option holders sometimes choose to exercise their buying rights even if share prices don’t increase as expected when there is a dividend coming up. Of course, this only makes sense when the amount of the dividend is enough to offset fees and still turn a profit for the option contract holder.
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Short Put Option Assignment
A contract to sell shares at a specific strike price is referred to as a put option. These are typically used when investors believe shares of a specific company will go down, and they want to protect existing assets or profit from this downturn in the stock’s price.
Put Option Assignment Example
It works like this: Shares of XYZ Co. are currently selling at $50 per share, but you believe the price is going to drop by 20 percent. You purchase an option to sell 100 shares at $45 within the next month, which is the price you originally paid when you bought the shares. You pay a premium of $0.25 per share, or $25 (for each option contract).
As expected, XYZ Co. experiences a dramatic loss, and shares drop to $38 each. Since you already own these shares, along with a put option, you can “put” them to an options contract holder.
Your transaction is assigned to a contract holder automatically, and the holder must purchase your shares at $45 each. This mitigates the loss you might have otherwise experienced when your stock lost value.
Even if you don’t already own the shares, you can still profit from a put option. You can buy the shares at their current price of $38, then sell them by exercising your option to sell at $45, or you can sell the contract itself. Others who own XYZ Co. shares are also looking for ways to offset some of their losses.
Option Assignment Can Be Good!
Selling call and put option contracts comes with significant risk, even for the most seasoned investors.
The upside is that when options expire without being exercised, contract writers profit from the premium fees collected. The downside for call contract writers is the potential loss of profit if share prices increase substantially and your options are assigned.
Writing put contracts is slightly less risky, in that contract writers can hold the purchased shares in hopes that prices eventually recover.
Those who hold options contracts risk the loss of their premium fees, but this can be a worthwhile gamble for a number of reasons.
Options can be used to protect a portfolio from the standard ups and downs of the market – a useful feature for investors who have short-term financial goals.
They can also offer an opportunity to speculate on future market changes with limited risk, as the only loss is the loss of premium fees.
To get started trading options, view risk graphs, and access free options trading tutorials, check out thinkorswim.
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