Options Bootcamp
Options 104: The Dark Side (Decay & Assignment)
Options are not "set and forget" assets. They rot. We discuss the non-linear nature of Time Decay and the mechanics of Exercise and Assignment.
The Curve of Decay
Time value does not decay in a straight line. It decays exponentially.
The Square Root Rule: A 3-month option decays at twice the rate of a 9-month option. As you get closer to expiration (especially the last 30 days), the value vanishes faster and faster.
This phenomenon is called Theta Decay. It is the enemy of the buyer and the friend of the seller.
Time Value Decay Curve
- value
Exercise & Assignment
Exercise: The holder (buyer) chooses to use their right to buy/sell stock. They notify their broker, who notifies the OCC (Options Clearing Corporation).
Assignment: The OCC randomly selects a brokerage firm that is "short" that option. That firm then assigns one of its customers.
If you sold an option, you can be assigned at any time. Once assigned, the obligation is absolute. You must deliver (or buy) the stock.
Early Exercise Risks
Usually, it makes no sense to exercise early (you lose the remaining time value). However, it happens in two main cases:
1. Dividends: A Call holder exercises the day before the ex-dividend date to capture the dividend.
2. Discount Arbitrage: If a Put option trades below its intrinsic value, arbitrageurs will buy and exercise immediately.
As a seller, you must be vigilant around dividend dates.
Key takeaways
- Time Decay accelerates as expiration approaches.
- Assignment is random and irrevocable.
- Watch out for "Automatic Exercise" at expiration.
- Early assignment is rare but happens near Dividend dates.
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