Exercise and assignment

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Exercise is the act of using the right an option grants: a call holder buys the shares at the strike, a put holder sells them at the strike. Assignment is the other side of the same event: a seller is selected to fulfill the obligation.

In practice, most listed options are never exercised. Holders who want out of a position generally close it in the market instead, because selling the option captures any remaining extrinsic value that exercising would forfeit.

At expiration, contracts that finish in the money are exercised automatically under clearing house rules; contracts out of the money lapse with no action needed.

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A worked example at expiration. A holder owns one $105 call and the stock closes at $112. Automatic exercise kicks in, and the position becomes 100 shares bought at $105, a cost of $10,500 for stock with a market value of $11,200. The account must be able to carry that stock position, which is why brokers may act ahead of expiration for holders who cannot.

Assignment runs through a chain. The clearing house tallies all exercises in a series and allocates them among member brokers, and each broker then allocates to its short customers, commonly at random. A writer of that $105 call is obligated to deliver 100 shares at $105 each, a sale bringing in $10,500 regardless of the $112 market price.

Before expiration, American-style equity options can be exercised on any trading day, though early exercise is uncommon and clusters in specific situations:

• Deep in-the-money calls just before an ex-dividend date, when the dividend is worth more than the remaining extrinsic value.
• Deep in-the-money puts when interest on the sale proceeds outweighs the extrinsic value given up.

The arithmetic behind both cases is the same: exercising surrenders whatever extrinsic value remains in the option's premium, so early exercise is economically rational only when that remainder is smaller than what exercising unlocks.

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The clearing house auto-exercises any equity option that finishes $0.01 or more in the money, measured against the official closing price on expiration day. Holders may override this with contrary exercise instructions through their broker, in either direction: declining exercise of an in-the-money contract, or exercising one that is nominally out of the money, before the broker's cut-off that evening.

For sellers, assignment can arrive on any trading day with American-style contracts, not only at expiration. The practical signal is extrinsic value: a short option trading near parity, with almost nothing left above intrinsic value, is a candidate for early assignment, most visibly on in-the-money calls the day before the underlying goes ex-dividend.

Cash-settled index options remove the stock leg entirely; exercise produces a cash transfer equal to the in-the-money amount, and being European style, they carry no early assignment at all. A final misconception worth correcting: assignment is not an adverse ruling or a penalty. It is the contract performing exactly as written, at the strike the writer agreed to.