Derivatives and options
We know options are contracts. What do we need to know when we're selling them?
The use of our credit card hinges on a contractual agreement that Visa or Mastercard will allow us to buy now and pay later. The agreement is that our creditors will pay for us when we make a purchase, and we promise to pay the creditors back within 30 days.
What if, instead of waiting the expected 30-days, the credit card company demands money from us at any time? This scenario describes how assignment works in the world of options trading.
Two sides of a contract
Exercising an option
The owner of the contract agreement can choose to force the agreement to be fulfilled at any time by exercising the option.
The biggest difference between a stock and an option is that the option represents the agreement or promise between two investors. For call options, the agreement is for one investor to buy stock from another. And for put options, the agreement is for an investor to sell stocks to another investor.
The contract owner is the one that can choose to buy or sell the stock that the contract is converting. By doing so, that investor is exercising his or her rights to the contract and the other party is assigned.
Let's walk through a quick example of how options can lead to an assignment.
In this lesson, we've broken down how assignment works on a very simple call option. In practice, options can have various terms and are rarely actually between two individual investors. Instead, market makers and clearinghouses often sit in the middle. Regardless of who is on the other end of our trade, as an investor selling options contracts, if we are assigned, we need to be prepared to fulfill our end of the bargain. If we don't understand what we're doing, we can quickly end up owing a lot of money.