In this article, we’ll dive deep into the concept of assignment risk in options trading, particularly when trading credit spreads. Assignment risk is a critical aspect of risk management for options traders, and understanding how to handle it can make a significant difference in your trading success.

Understanding Assignment Risk

Assignment risk refers to the possibility that the person to whom you’ve sold an option may decide to exercise that option, requiring you to fulfill your obligation. This can happen at any time before expiration, but it becomes more likely as the option moves deeper into the money.

Let’s break down the basics:

• When you enter a credit spread trade, you sell one option contract and simultaneously buy another option contract with different strike prices.
• The option you sold (the short option) carries the risk of assignment if it is in the money.
• Assignment means that the holder of the option you sold wants to execute the contract. This can result in you having to buy or sell the underlying asset, depending on whether it’s a call or put option.

How To Know You Are In Trouble

The degree of assignment risk you face depends on several factors, primarily how deep in the money your short option is and the time remaining until expiration.

• In the Money: The deeper your short option is in the money, the higher the chances of assignment. The closer the option is to its strike price, the more profitable it becomes for the option holder to exercise it.
• Time Remaining: Assignment risk typically increases as you approach the expiration date of the options. This is especially true for American-style options, which can be exercised at any time before expiration.

Managing Assignment Risk

Now that we understand what assignment risk is and how it can impact your credit spread trades, let’s explore strategies for managing this risk.

Strategy 1: Close Out the Position

The most straightforward way to eliminate assignment risk is to close out the entire credit spread position. By doing this, you remove both the short and long options from your portfolio. While this might result in a small loss, it’s a clean way to avoid the uncertainty associated with assignment.

Strategy 2: Use Protective Puts or Calls

Protective puts or calls are options you can buy to hedge your position when assignment risk increases. Depending on your market outlook, you can choose one of the following:

• Protective Put (For Bearish Markets): If you anticipate the stock or underlying asset will continue to decline, you can buy a protective put at a lower strike price to offset potential losses on the short put in your credit spread.
• Protective Call (For Bullish Markets): If you believe the asset will rally, you can purchase a protective call at a higher strike price to counteract potential losses on the short call in your credit spread.

Strategy 3: Roll Your Position

Rolling your position involves simultaneously closing your existing credit spread and opening a new one with a different expiration date and strike prices. This can help you avoid assignment while extending your trade duration.

Conclusion

Assignment risk is an integral part of options trading, especially when trading credit spreads. By understanding the factors that influence assignment risk and implementing appropriate strategies, you can effectively manage and minimize potential losses.

Remember that risk management is a crucial component of successful options trading. Each strategy has its advantages and disadvantages, so it’s essential to align your approach with your market outlook and risk tolerance.

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Thanks for reading 🙂
Austin Bouley
CEO & Chief Strategy Officer