When a trader obtains a call option, that trader has the right to purchase the underlying asset at the strike price on the expiration day. The buyer of a put option in turn has the right to sell an underlying asset at the strike price when the expiration day arrives. In both cases the buyer is said to have the right to exercise the option.
The counterpart to this agreement is the seller, who in the case of call options has the obligation to sell an underlying asset at the strike price and in the case of put options to buy it at the strike price.
If the buyer of the option exercises their right in terms of the option, the seller is said to get exercised or assigned. Naked call or put options get exercised automatically if they expire In The Money – otherwise they simply expire worthless.
Exercise Explained
The whole concept of ‘getting exercised’ or ‘getting assigned’ is often blown out of proportion. If one carefully analyses what actually happens it is not as terrible as it sounds.
If a trader should sell naked call options on stocks, for example, and they expire In The Money, the trader has to deliver the shares at the strike price, regardless of the current market price. If the strike price of the options was $120 and by expiration the stocks are trading for $130, the trader actually has to buy stocks at $130 (if he or she doesn’t already own them) and sell them for $120 each to the owner of the long call options – at a loss of $10 per option, i.e. $1000 per contract.
A trader selling naked put options on stocks is in the reverse position: he or she has to buy the shares at the strike price regardless of the market price at expiration. If the strike price of the options was $80 and the share price drops to $70 by expiration, this trader has to buy the shares from the owner of the put options for $80 per share while the market price is only $70. Once again this represents a loss of $10 per share.
Getting exercised compared to owning stocks
If we compare the position of someone who owns stocks with that of a trader who sells naked puts, for example, we will see that their profit/loss scenarios are not that different.
Consider the case of Investor Jack who owns 100 shares of Company ABC. The shares are currently worth $100 each, a total investment of $10 000 therefore. Trader Jill owns no shares. She, however, sells 1 naked put options contract representing 100 shares in company ABC with a strike price of $100.
Should the price of Company ABC shares drop to $85 by expiration, Investor Jack will lose $15 per share with a total loss of $15 x 100 = $1 500.
Trader Jill will be exercised and she will have to buy 100 shares of Company ABC at $100 each despite the fact that they are only worth $85 each at current prices. She also makes a loss of $15 x 100 = $1 500.
The difference between the two is that Trader Jill received a premium when she sold the put options. Assume this was $4 per option. Her total loss is therefore $1500 – $4 x 100 = $1 500 – $400 = $1100.
If the share price of Company ABC remained stagnant at $100, Trader Jill would still get to keep the premium she received for selling the put options ($400), while the stock owner would show no profit at all.
Conclusion:
While there is no doubt that getting exercised/assigned can be very costly to an options seller, the maximum loss is no bigger than that of someone who was long or short an actual stock position. In many cases the options seller will actually be in a better position.