"Why am I Not Getting Assigned!?" Understanding Intrinsic Value

This post is an example of the content I intend to provide tier-1 (Henchman - $2) patrons 

New members of Theta Gang appear to attracted to The Wheel as a strategy. The Wheel is a strategy in which a trader sells cash-secured puts until he gets assigned shares, and then switches to selling covered calls to continue pulling premium. This is a relatively low-risk trading strategy that I utilize heavily. However, there is assignment risk (the risk that your short calls or puts will be assigned) that the trader must consider. To effectively use The Wheel, a trader must understand when his trade is likely to be assigned, and that means understanding intrinsic value.

There seems to be a misunderstanding among new options traders regarding when they should expect early assignment. New traders tend to believe they should anticipate assignment as soon as their cash-secured puts are in-the-money (ITM), but this is far from the truth. This post will address this misunderstanding.

tl;dr for those not interested in reading this whole thing: don't expect to get assigned early as long as the option you sold still has extrinsic value on it unless ex-dividend date is tomorrow.

Understanding Assignment Risk

When a trader sells calls or puts, there are a few situations in which he is likely to be assigned:

1) The contract expires in-the-money (ITM);
2) There is an approaching dividend which, if added to the intrinsic value, exceeds the value of a contract; and
3) The contract is very deep ITM and the delta is close to 1.0.

Situation 1 is obvious: if your short call or put expires ITM, you are almost guaranteed to get assigned. Situations 2 and 3 require an understanding of intrinsic value. Let's explore these situations to help understand when you should anticipate early assignment.

What is Intrinsic Value?

There are two types of value associated with an option contract's price. The first is intrinsic value. The other goes by several names - extrinsic value, theta value, and time value - but they all refer to the same thing. I prefer extrinsic value.

Intrinsic Value: The actual value of an in-the-money contract that the buyer would realize if he executes the contract.
Extrinsic Value: The additional value of a contract on top of the intrinsic value, such as value derived from time to expiration, volatility, and liquidity.

Let's expand on what intrinsic value means. Let's say WSB is trading for $30. Any call contract below the $30 strike would be ITM, and would therefore have intrinsic value. Let's say a trader buys a call at the $28 strike. This put is ITM, and therefore carries intrinsic value. But how much?

Intrinsic value is the amount of money that a trader would gain if he executed his contract and then immediately closed the position. In the example above, if a trader were to buy a call at the $28 strike for WSB trading at $30, he could immediately execute the contract and buy 100 shares for $28 each, or $2,800 total. He could then sell the shares for $30 each, or $3,000 total. On that transaction, the trader will have made $200. The intrinsic value of the contract is, therefore, $2. 

But traders cannot make money by simply buying ITM calls and then executing them; that would be ridiculous. It would make no sense to sell ITM calls either, as the seller would immediately be assigned and forced to sell his shares. Let's talk about why that doesn't work, and, more importantly, talk about why your covered calls aren't getting assigned as soon as they go ITM.

Intrinsic Value's Effect on Assignment

Let's look at an example of Luckin Coffee, LK.

On January 31, LK traded at $31.99. Let's call it an even $32 for simplicity. Look at the $31 strike. A trader could buy the call and immediately execute it to purchase 100 shares for $31 each. He could then sell those shares for $32 and thus make a $100 on the transaction. The $31 strike therefore has $1 of intrinsic value (remember that options contracts represent 100 shares).

But there is a problem here- to execute the $31 strike, a trader has to buy the call first. And as you can see above, that call is selling for $390. How is it that a call that only has $1 of intrinsic value is trading for $3.90? The remaining $2.90 is extrinsic value. When someone buys a call, he is doing it because he thinks the stock will go up. By carrying $2.90 of extrinsic value, this contract indicates that call buyers believe LK will gain at least $2.90 of intrinsic value by the Febuary 7 expiration. In other words, buyers of the $31 call believe LK will reach at least $34.90 by Febuary 7.

 The extrinsic value is influenced by multiple factors, including volatility, time to expiration, and liquidity. These will be explored in another article. For now, just be aware that extrinsic value is the additional value of a contract beyond its intrinsic value.

How does intrinsic value affect assignment?

For every option buyer, there is an option seller. If you're in Theta Gang, that's you. Let's sell a covered call on LK at the $31 strike. We would receive $390 for doing so, $100 of which is intrinsic value and $290 of which is extrinsic value. But our call is ITM. Should we expect assignment? No.

The guy we just sold our call to just spent $390 on the call. But when a buyer executes a contract, he only gets to assume the intrinsic value. The extrinsic value is lost; you don't get the premium back when you execute- you just get the intrinsic value, and even then, the position will be an unrealized gain unless you immediately close your position on shares. Therefore, the buyer would lose all the extrinsic value when he executes the contract. Since he would only get $100 for a contract he just spent $390 on, it does not make sense to execute the contract. If he wants out, he will just sell the call to someone else.

What does this mean for you as an option seller? No one is going to execute his contract early if he can sell the contract for more than its intrinsic value. He would just sell the contract to someone else, and you as the original seller would not even know the contract owner changed hands. 

If you sold the $31 call on LK and were forced to sell shares at $31 when the stock is trading at $32, you should be thankful. You get to buy back the shares at a $100 loss but still keep the $390 premium. You'd make $290 profit if that were to happen.

Ultimately, you should anticipate assignment only if there is very little (<$0.02) to no extrinsic value left on a contract. This always happens at 4:00 PM on expiration day because there is no time remaining before expiration and therefore no extrinsic value.

Exceptions to this rule

There are two exceptions to this rule, and you can generally avoid them if you want to.

The first exception happens when a stock has an ex-dividend date the next day, and the dividend, if added to the intrinsic value of the stock, exceeds the contract's total value. For example, if you sold the $29 call on WSB and the stock were trading for $29.04, the contract would have $0.04 of intrinsic value. As long as the call contract were trading for more than $0.04, you shouldn't expect early assignment because the buyer would be better off selling the contract than executing early. However, if the next day, WSB were paying a dividend of $0.10/share ($10/100 shares), then you should anticipate assignment as long as the call is selling for less than $0.10. The option buyer would be willing to sacrifice the $4 of intrinsic value to execute the call early to take control of the 100 shares and thus receive the $10 dividend. This $10 dividend is more valuable to him than the $4 option contract. Pay attention to ex-dividend dates if it is important to you to avoid early assignment.

Secondly, be aware that deep ITM calls with a delta close to 1.0 tend to carry very little extrinsic value. Let's look at an example.

On January 31, AAPL is trading for $309.01. The $120 call expiring on Feb 21 is trading for $189.45. $189.01 of that is intrinsic value. Buyers of this contract are factoring in only $0.44 of price increase by February 21, and therefore there is only $0.44 of extrinsic value on this contract. As contracts get very deep in the money, they tend to carry less and less extrinsic value. The reasons for this are complex, but all in all, assume that super-low extrinsic value contracts like this are at higher risk of early assignment because call owners this deep ITM are willing to sacrifice small amounts of extrinsic value if it means assuming such a low basis on a valuable stock. 

Further, look at the Delta. Delta indicates how much a contract will move for every $1 of movement in the underlying stock price. In this example, for every $1 of AAPL increase, the $120 call price will increase by $0.995. At that point, holding the shares is just about as valuable as holding the call, and the intangible value of holding the shares (future dividend, voting rights, shareholder reports), might be worth the 1/2 penny less you'd lose if AAPL drops, and since AAPL is probably more likely to rise than fall (because it's AAPL), you might as well take the shares.

Basically, know this: if the delta on a contract you sold is >0.99, you're at risk of early assignment. This is evident in 1ronyman's legendary trade:  https://www.youtube.com/watch?v=6x14dVOrW1U 

Summary

You are unlikely to be assigned early. I have been selling options since 2013 and have never been assigned early (although I've been assigned on expiration plenty of times).

You should anticipate assignment whenever an ITM contract has little to no extrinsic value left on a contract and it carries only intrinsic value. This happens every expiration day, but may also happen with very deep ITM contracts.

Also, consider dividends. If intrinsic value + dividend = more than the contract's current price, expect assignment.

If none of the above apply, you are exceedingly unlikely to get assigned. I won't say it cannot happen, but you will likely go your entire trading career without getting assigned early unless one of the above circumstances applies to you.

Disclaimer

This post is Mikey Millions' view based on his experience, understanding, and good faith. Please do your own analysis before making options trades with the understanding that Mikey is not a financial adviser. While Mikey is confident that his statements are valid, consider corroborating his statements with other sources and contacting a financial adviser to help manage your finances.