<I>TSC</I> Options Forum: Tips on Learning Your Assignment

Here's a look at the dynamics that come into play when options are exercised.
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Steve:Please explain how you might end up with a long position through assignment as you stated in your Newell Rubbermaid example. What is assignment?-- J.N.

This question refers to a recent article that discussed

selling puts as a way of establishing a bullish position. Because a number of readers have asked about the subject, here's a quick review of exercise and assignment:

The owner of an option has the right, but not the obligation, to a) buy shares at the strike price if it's a call option, or b) sell shares at the strike price if it's a put option. By deciding to buy (sell) a call (put) option, the owner is "exercising" his or her rights.

Conversely, those who sell options have entered into a promise to either a) sell or deliver shares at the specified strike price in the case of calls, or b) buy shares at the specified strike price in the case of puts.

When the seller of an option is asked to make good on that promise, it is called being "assigned." Rarely do options ever get exercised and therefore assigned unless they are in the money -- i.e., the underlying shares are above the strike in the case of calls or below the strike price in the case of puts.

For example, sticking with puts, because they're a little more difficult to grasp, if XYZ shares are trading at $24.50, anyone owning put options with a strike price of $25 (generally speaking, equity options that are at least 50 cents in the money are exercised "by exception" automatically. For more on the specifics, see articles linked below) or higher will exercise their right to sell XYZ at that specified strike price. This means those who are short XYZ put options with a strike price above $25 will be assigned, meaning they're obligated to buy shares at the specified strike price.

Assume that on Tuesday, with

Newell Rubbermaid

(NWL) - Get Report

trading at $25.45, you sold 10 March $25 puts for 40 cents each. If the underlying shares are below $25 on the March 19 expiration, your puts will be assigned, obligating you to buy 1,000 shares of Newell at $25 each. Note that the effective cost basis of the purchase will be $24.60 -- the strike price minus the sale price or premium collected on the put option sold short.

While most equity options are American style, meaning they can be exercised at any time prior to expiration, the bulk of exercise and assignment notices occur on the last day of trading. For more on the definitions and rules, please see this previous article on

exercise and assignment.

Steve:What happens to long options, say a '06 leap, when the AWE deal closes for $15cash in '05? Can the option holder get left with nothing if he doesn't act by some uncertain deadline? Do you see what I mean? Thanks, -- S.W.

Yeah, buddy, I see what you mean. Actually, last week's

Options Forum on how mergers affect options prompted many readers to ask for an expanded explanation on what happens to their options when the deal closes. While I did mention that "those short in-the-money calls would be assigned and have to deliver either shares or the cash," I didn't address what the owner of in-the-money calls should do or expect.

Cingular

has agreed to pay $15 a share in cash for

AT&T Wireless

(AWE)

. Once the deal closes, shareholders will have a time window in which to tender their stock and receive the cash. It's during this tender period that many owners of in-the-money calls also will exercise their right to receive stock and in turn tender the shares for the cash.

But don't worry: Even if for some reason (let's say tax purposes or simple forgetfulness) you choose not to exercise your in-the-money call options, you won't be left empty-handed. When the deal eventually closes, the options will become "cash settled," and you will get the monetary value of the option based on a share price of $15 a share. Of course, you can always sell out the calls anytime prior to the cash settlement.

And again I recommend going to

this page on the CBOE Web site to look up the specifics regarding individual issues.

There has been an increasing number of requests for reading and option education suggestions. And because I'll be on vacation (actually, I'm there now as you read this) this week, this seems like an opportune time to redirect you to some helpful links. The Chicago Board of Options Exchange Web site's

Learning Center is a great place to start. On that same page, you can go to the Exchange's bookstore, find courses (both live and online) offered by the Options Institute, and get definitions and explanations on just about anything to do with options.

Another great educational site is

Optionetics. It will lead you to a list of books, newsletters and seminars, and it also provides more detailed explanations of specific strategies and offers a host of analytic tools.

While I try to respond individually to all questions and comments, I'm sure there are some I've missed or won't respond to with perfect promptness; please be patient. (To make sure I open your mail, please put something pertinent in the subject line.)

Happy learning. See you next week.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.