Investing Archives | Page 144 of 194

Jun

2023

How a Minsky Moment Happens, and How to Spot One

By Colin Dodds | Growing Wealth, invest, Investing, Terminology | Comments Off

A Minsky moment is an economic term describing a period of optimism that ends with a market crash. It describes the point at which a market boom marked by speculative trading and increasing debt suddenly gives way to a freefall marked by plunging market sentiment, asset values, and economic activity.

It is named for American economist Hyman Minsky, who studied the characteristics of financial crises, and whose “financial instability hypothesis” offered reasons why financial markets were and would be inherently unstable. Minsky died in 1996, and the phrase “Minsky moment” was coined in 1998, when a portfolio manager used it in reference to the 1997 Asian debt crisis, which was widely blamed on currency speculators.

How Does a Minsky Moment Happen?

A Minsky Moment refers to something sudden, though the economist maintained that it doesn’t arise all at once. He identified three stages by which a market builds up to the convoluted speculation and complete instability that finally undoes even the longest bull markets.

1. The Hedge Phase: This often comes in the wake of a market collapse. In this phase, both banks and borrowers are cautious. Banks only lend to borrowers with income to cover the principal of the loan and interest payments; and borrowers are wary of taking on more debt than they’re highly confident they can repay entirely.

2. Speculative Borrowing Phase: As economic conditions improve, debts are repaid and confidence rises. Banks become willing to make loans to borrowers who can afford to pay the interest but not the principal, but the bank and the borrower don’t worry because most of these loans are for assets — stocks, real estate and so on — that are appreciating in value. The banks are also betting that interest rates won’t go up.

3. The Ponzi Phase: The third and final phase leading up to the Minsky Moment is named for the iconic fraudster Charles Ponzi. Ponzi invented a scheme that offers fake investments, and gathers new investors based on the returns earned by the original investors. It pays the first investors from new investments, and so on, until it collapses.

In Minsky’s theory, the Ponzi phase arrives when confident borrowers and lenders graduate to a new level of risk-taking and speculation: when lenders lend to borrowers without enough cash flow to cover the principal payments or the interest payments. They do so in the expectation that the underlying assets will continue rising, allowing the borrower to sell those assets at prices high enough for them to cover their debt.

The longer the growth swing in the market, the more debt investors take on. While those investments are still rising and generating returns, the borrowers can use that money to pay off the debt and the interest payments. But assets eventually go down in value, in any market, even just for a while.

At this point, the investors are relying on the growth of those assets to repay the loans they’ve taken out to buy them. Any interruption of that growth means they can’t repay the debt they’ve taken on. That’s when the lenders call in the loans. And the borrowers have to sell their assets — at any price — to repay the lenders. When there are thousands of investors doing this at the same time, the values of the underlying assets plummet. This is the Minsky moment.

In addition to plunging prices, a Minsky moment is usually accompanied by a steep drop in market-wide liquidity. That lack of liquidity can stop the daily functioning of the economy, and it’s the part of these crises that causes central banks to intervene as a lender of last resort.

The Minsky Moment and the 2008 Subprime Mortgage Crisis

The 2008 subprime mortgage crisis offered a very clear and relatable example of this kind of escalation, as many people borrowed money to buy homes they couldn’t afford. They did so believing that the property value would go up fast enough that they could flip the house to cover their borrowing costs, while earning a tidy profit.

Minsky theorized that a lengthy economic growth cycle tends to generate an outsized increase in market speculation. But that accelerating speculation is often funded by large amounts of debt on the part of both large and small investors. And that tends to increase market instability and the likelihood of sudden, catastrophic collapse.

Accordingly, the 2008 financial crisis was marked by a sudden drop and downward momentum fueled investors selling assets to cover short-term debts. Some of those included margin calls, which are when an investor is forced to sell securities to cover the collateral needed to borrow money from a brokerage.

How to Predict the Next Minsky Moment

While Hyman Minsky provided a framework of the three escalating phases that lead up to a market collapse, there’s no way to tell how long each phase will last. Using its framework can help investors understand where they are in a broader economic cycle, but people will disagree on how much debt is too much, or the point at which speculation threatens the stability of the markets.

Most recently, market-watchers keep an eye on the high rates of corporate debt in trying to detect a coming Minsky moment. And even the International Monetary Fund has sounded warning bells over high debt levels, alongside slowing growth around the planet.

But other authorities have warned of other Minsky moments over the years that haven’t necessarily happened. It calls to mind the old joke: “The stock market has forecast nine of the last five recessions.”

The Takeaway

A Minsky moment is named after an economist who described the way that markets overheat and collapse. And the concept can help investors understand where they are in a market cycle. It’s a somewhat high-level concept, but it can be useful to know what the term references.

There’s also a framework that may help investors predict, or at least keep an eye out for, the next Minsky moment. That said, nobody knows what the future holds, so that’s important to keep in mind.

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Jun

2023

What Are Hedge Funds and How Do They Work?

By Laurel Tincher | Financial Independence, Growing Wealth, invest, Investing | Comments Off

A hedge fund is an investment vehicle that invests in securities and other assets with money pooled from investors. They’re similar to mutual funds or exchange-traded funds, but hedge funds rely on high-risk strategies and come with much higher fees. Because of this, they’re subject to less stringent regulations, and only certain types of investors have access to these funds.

While most investors may not engage with a hedge fund, especially younger ones, it can be useful to know what they are and how they work.

What Is a Hedge Fund?

Hedge funds are set up by a registered investment advisor or money manager, often as a limited liability company (LLC) or a limited partnership (LP). They differ from mutual funds in that they have more investment freedom, so they’re able to make riskier investments.

By using aggressive investing tactics, such as short-selling, debt-based investing, and leveraging hedge funds can potentially deliver higher-than-market returns, but they also have higher risks than other types of investments. In addition to traditional asset classes, hedge funds can a diverse array of alternative assets, including art, real estate, and currencies.

Hedge funds tend to seek out short-term investments rather than long-term investments. Of course assets that have significant short-term growth potential can also have greater short term losses.

Historically, hedge funds have not performed as well as safer investments, such as stock market indices. However, the goal of hedge funds isn’t necessarily to outperform the stock market. Investors also use hedge funds to provide growth during all phases of market growth and decline, providing diversification to a portfolio that also contains stocks, cash, and other investments.

Generally speaking, only qualified investors and institutional investors are able to invest in hedge funds, due to their risks and the high fees that get paid to fund managers.

Types of Hedge Funds

Each hedge fund has a different investing philosophy and invests in different types of assets. Some different hedge fund strategies include:

• Real estate investing

• Junk bond investing

• Specialized asset class investing such as art, music, or patents

• Long-only equity investing (no short selling)

• Private equity investing, in which the fund only invests in privately-held businesses. In some cases the hedge fund gets involved in the business operations and helps to take the company public.

What Is a Hedge Fund Manager?

Hedge funds are run by investment managers who make investment decisions and manage the risk level of the fund. If a hedge fund is profitable, the hedge fund manager can make a significant amount of money, often up to 20% of the profits.

Before selecting and investing in a hedge fund, it’s important to look into the fund manager’s history as well as their investing strategy and fees. This information can be found on the manager’s Form ADV, which you can find on the fund’s website as well as through the Security and Exchange Commission’s (SEC) website.

Who Can Invest in a Hedge Fund?

Hedge funds are not open to the general public, and there are several requirements to be able to invest in them. In order for an individual to invest, they must be an accredited investor. This means that they either:

• Have an individual annual income of $200,000 or more. If the married investors must have a combined income of $300,000 per year or more. They must have had this level of income for at least two consecutive years and expect to continue to earn this level of income.

• Or, the investor must have an individual or combined net worth of $1 million or more, excluding their primary residence.

If the investor is an entity rather than an individual, they must:

• Be a trust with a net worth of at least $5 million. The trust can’t have been formed solely for the purpose of investing, and must be run by a “sophisticated” investor, defined by the SEC as someone with sufficient knowledge and experience with investing and the potential risks involved.

• Or, the entity can be a group of accredited investors.

How to Invest in a Hedge Fund

Investing in hedge funds is risky and involves a deep understanding of financial markets. Before investing, there are several things to consider:

The Fund’s Investing Strategy

Start by researching the hedge fund manager and their history in the industry. Look at the types of assets the fund invests in, read the fund’s prospectus and other materials to understand the opportunity cost and risk. Generally speaking, the higher the risk, the higher potential returns.

In addition, you need to understand how the fund evaluates potential investments. If the fund invests in alternative assets, these may be difficult to value and may also have lower liquidity.

Understand the Minimums

Investment requirements can range between $100,000 to $2 million or more. Hedge funds have less liquidity than stocks or bonds, and some require that money stays invested in the fund for a specific amount of time before it can be withdrawn. It’s also common for there to be lock-up periods for funds and for there to only be certain times of year when funds can be withdrawn.

Confirm You Can Make the Investment

Make sure that the fund you’re interested in is an open fund, meaning that it accepts new investors. Financial professionals can help with this research process. Each hedge fund will evaluate an individual’s accreditation status using their own methods. They may require personal information about income, debt, and assets.

Understand the Fees

Usually hedge funds charge an asset management fee of 1-2% of invested assets, as well as a performance fee of 20% of the hedge fund’s profits.

The Takeaway

Hedge funds offer investors — usually, wealthier investors — the chance to invest in funds that are usually high-risk, but offer high potential returns. There are many rules surrounding hedge funds, and many investors may not even consider them as a part of an investing strategy.

For accredited investors, investing in a hedge fund may be one part of a diversified portfolio, although it depends on the investor’s risk tolerance, time horizon, and investing goals. If you’re not an accredited investor, or you’re worried about the risks associated with hedge funds, it may make more sense for you to consider other types of investments or to stick with ETFs, mutual funds, or funds of funds that emulate hedge fund strategies.

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Jun

2023

What Is Deflation and Why Does It Matter?

By Ashley Kilroy | Financial Independence, Growing Wealth, invest, Investing | Comments Off

Deflation is essentially the opposite of inflation. It occurs when the prices consumers pay for goods and services goes down. That means that consumers can purchase more with the same amount of money.

There are many factors that cause deflation, which happens when the supply of goods and services is higher than the demand for them. While deflation can have some benefits to consumers, it’s often a sign of trouble for the overall economy.

What Happens During Deflation?

In addition to knowing what inflation is, it’s important to understand how it impacts the economy. In a deflationary economy, prices gradually drop and consumers can purchase more with their money. In other words, the value of a dollar rises when deflation happens.

It’s important not to confuse deflation with disinflation. Disinflation is simply inflation decelerating. For example, the annual inflation rate may change from 5% to 3%. This variation still means that inflation is present, just at a lower rate. By contrast, deflation lowers prices. So, instead of prices increasing 3%, they may drop in value by 2%.

Although it may seem advantageous for consumer purchasing power to increase, it can accompany a recession. When prices drop, consumers may delay purchases on the assumption that they can buy something later for a lower price. However, when consumers put less money into the economy, it results in less money for the service or product creators.

The combination of these two factors can yield higher unemployment and interest rates. Historically, after the financial crises of 1890, 1893, 1907, and the early-1930s, the United States saw deflationary periods follow.

How Is Deflation Measured?

Economists measure deflation the same way they measure inflation, by first gathering price data on goods and services. The Bureau of Economic Analysis (BEA) and the Bureau of Labor Statistics (BLS) record and monitor this type of data in the United States. They collect pricing information that they then put into buckets reflecting the types of goods and services consumers generally use.

While these buckets do not include every product and service; they offer a sample of items and services consumed. In the United States, economists incorporate these prices into an indicator known as the Consumer Price Index (CPI).

Then, economists can compare the CPI to previous years to determine whether the economy is experiencing inflation or deflation. For example, if the prices decrease in a period compared to the year before, the economy is experiencing deflation. On the other hand, if prices increase compared to the previous year, the economy is experiencing inflation.

What Causes Deflation?

Deflation comes from a swing in supply and demand. Typically, when demand dwindles and supply increases, prices drop. Factors that may contribute to this shift include:

Rising Interest rates

When the economy is expanding, the Federal Reserve may increase interest rates. When rates go up, consumers are less likely to spend their money and may keep more in high interest savings accounts to capitalize on the increase in rates.

Also, the cost of borrowing increases with the rise of interest rates, further discouraging consumers from spending on large items.

Decline in Consumer Confidence

When the country is experiencing economic turbulence, like a recession, consumers spend less money. Because consumers tend to worry about the direction of the economy, they may want to keep more of their money in savings to protect their financial well-being.

Innovations in Technology

Technological innovation and process efficiency ultimately help lower prices while increasing supply. Some companies’ increase in productivity may have a small impact on the economy. While other industries, such as oil, can have a drastic impact on the economy as a whole.

Lower Production Costs

When the cost to produce certain items, such as oil, decreases, manufacturers may increase production. If demand for the product stagnates or decreases, they may then end up with excess supply. To sell the product, companies may drop prices to encourage consumer purchases.

Why Does Deflation Matter?

Although falling prices may seem advantageous when you need to purchase something, it’s always not a good sign for the economy. Many economists prefer slow and unwavering inflation. When prices continue to rise, consumers have an incentive to make purchases sooner, which further boosts the economy.

One of the most significant impacts of deflation is that it can take a toll on business revenues. When prices fall, businesses can’t make as much money.

The drop in business profits makes it challenging for companies to support their employees, leading to layoffs or pay cuts. When incomes go down, consumers spend less money. So deflation can create a domino effect impacting the economy at many different levels, including lower wages, increased unemployment, and falling demand.

Deflation During The Great Depression

The Great Depression is a significant example of the potential economic impact of a deflationary period. While the 1929 stock market crash and recession set this economic disaster off, deflation heavily contributed to it. The rapid decrease in demand along with cautious money hoarding led to falling prices for goods and services. Many companies couldn’t recover and shut down. This caused record-high unemployment in the United States, peaking at 25%, and in several other countries as well.

During this time, the economy continued to experience the negative feedback loop associated with deflation: cash shortages, falling prices, economic stagnation, and business shutdowns. While the United States has seen small episodes of deflationary periods since the Great Depression, it hasn’t seen anything as substantial as this event.

How to Manage Deflation

So, what can the government do to help regulate inflation? For starters, the Federal Reserve can lower interest rates to stimulate financial institutions to lend money. The Fed may also purchase Treasury securities back to increase liquidity that may help financial institutions loan funds. Those initiatives can increase the circulation of the money in the economy and boost spending.

Another way to manage deflation is with changes in fiscal policy, such as lowering taxes or providing stimulus funds. Putting more money in consumers’ pockets encourages an increase in spending. This, in turn, creates a chain effect that may increase demand, increase prices, and move the economy out of a deflationary period.

The Takeaway

Deflation refers to a period that can be thought of as the opposite of inflation. It occurs when the prices consumers pay for goods and services goes down, which means that consumers can purchase more with the same amount of money.

When the economy is experiencing some turbulence, some investors may choose to keep their money in savings. On the other hand, other investors may see falling prices as an opportunity to purchase securities at a discount, either to hold or to sell when the economy recovers. Like any other investment strategy, investors must base their investment decisions on their personal preferences since there are no guaranteed results.

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Jun

2023

What is the Difference Between EBIT and EBITDA?

By Rebecca Lake | Growing Wealth, invest, Investing, Terminology | Comments Off

EBIT and EBITDA are two common ways to calculate a company’s profits, and investors may come across both terms when reviewing a company’s financial statements. Though they appear similar, they can present two very different views of a company’s income and expenses.

If you’re an investor or you own a business, it’s important to understand the difference between EBIT and EBITDA and know why the distinction matters.

What Is EBIT?

EBIT is a way to measure a company’s operating income. So, what does EBIT stand for in finance? It’s an acronym that stands for “earnings before interest and taxes”.

Here’s a look at what each of those components means:

• Earnings: This is the net income of a company over a specified period of time, such as a quarter or fiscal year.

• Interest: This refers to interest payments made to any liabilities owed by the company, including loans or lines of credit.

• Taxes: This refers to any taxes a company must pay under federal and state laws.

The formula for calculating EBIT is simple.

EBIT = Net income + Interest + Taxes

The EBIT calculation assumes you know a company’s net income. To determine net income, you would use this formula:

Net income = Revenue – Cost of Goods Sold – Expenses

In this formula, revenue means the total amount of income generated by goods or services the company sells. Cost of goods sold refers to the cost of making or acquiring any goods the company sells, including labor or raw materials. Expenses include operating costs such as rent, utilities or payroll.

EBIT should not be confused with EBT, or earnings before tax. Earnings before tax is used to measure profits with taxes factored in, but not any interest payments the company owes. You may use this metric to evaluate companies that are subject to different taxation rules at the state level.

You can find EBIT listed on a company’s income or profit and loss statement alongside other important financial ratios, such as earnings per share (EPS).

Is Depreciation Included in EBIT?

The short answer is no, depreciation is not included in the context of the EBIT formula. But you will see depreciation factored in when calculating EBITDA.

What EBIT Tells Investors

Knowing the EBIT for a company can tell you how financially healthy that company is based on its business operations. Specifically, EBIT can tell you things like:

• How much operating income a company needs to stay in business

• What level of earnings a company generates

• How efficiently the company uses earnings when debt obligations aren’t factored in

EBIT can be useful in determining how well a company manages business operations before external factors like debt and taxes come into play. It can also help to create a framework for evaluating whether certain actions, such as a stock buyback, are a true sign that a company is struggling financially.

You can also use EBIT to determine interest coverage ratio. This ratio can tell you how easily a company is able to pay interest on outstanding debt obligations. To find the interest coverage ratio, you’d divide a company’s earnings before interest and taxes by any interest paid toward debt for the specific time period you’re measuring. As an investor, this ratio can give you insight into how well a company is able to keep up with its current debts and any debts it may take on down the line.

What Is EBITDA?

EBITDA is another acronym you may see on financial statements that stands for “earnings before interest, taxes, depreciation, and amortization”. In terms of the first three terms, the breakdown is exactly the same as for EBIT. Plus there are two new additions:

• Depreciation: This term is used to refer to the decline in an asset’s value over time due to things like regular use, wear and tear or becoming obsolete.

• Amortization: This term also applies to a decline in value but instead of a tangible asset, it can be used for intangible assets. Amortization can also be referred to in the context of borrowing. For example, a business loan amortization schedule would show how the balance declines over time as payments are made.

So what is the EBITDA formula? It looks like this:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

Alternately, you can substitute this formula instead:

EBITDA = Operating Profit + Depreciation + Amortization

In this formula, operating profit is the same thing as EBIT. So to calculate EBITDA, you’d first need to calculate earnings before interest and taxes.

You should be able to find all the information you need to calculate EBITDA on a company’s income statement, though you may also need a cash flow statement for an accurate calculation.

EBIT vs EBITDA: Which is Better?

Compared to EBIT, EBITDA offers a clearer snapshot of a company’s net cash flow and how money is moving in or out of the business.

Calculating the earnings before interest, taxes, depreciation, and amortization can offer a fuller picture of a company’s financial health in terms of how operational decision-making affects profitability. It can also be useful when calculating valuations for different companies and/or comparing a business to its competitors.

While EBIT and EBITDA can be a starting point for choosing where to put your money, it’s also helpful to consider other fundamental ratios such as earnings per share or price-to-earnings ratio. Active traders who are interested in benefiting from market momentum, may consider technical analysis indicators instead.

Drawbacks of EBIT vs EBITDA

While EBIT and EBITDA can be useful, there are some potential issues to be aware of. Chiefly, neither formula is considered part of Generally Accepted Account Principles (GAAP). This is a uniform set of standards that’s designed to encourage transparency and accuracy in accounting for corporations, governments and other entities.

In other words, EBIT and EBITDA don’t have any official seal of approval from an accounting authority. That means companies can manipulate the numbers in their favor, if they choose to.

Here’s why: The better a company looks on paper, the easier it may be to attract investors or qualify for financing. Companies that are struggling behind the scenes may use inflated numbers or leave out critical information when calculating EBIT or EBITDA to appear more financially stable than they are.

That could potentially lead to losses for investors who choose to put money into a company because they accepted EBIT or EBITDA calculations at face value. So it’s important to dig deeper when deciding where to invest, as these numbers may not provide a full picture of a company’s financial situation.

The Takeaway

EBIT, or earnings before interest and tax, and EBITDA, or earnings before interest, tax, depreciation and amortization, are two ways to assess the financial health of a company. To recap, EBIT measures operating income, and EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.”

But note that these figures can be manipulated by companies looking to present a rosy outlook to investors, so as always, it’s a good idea to research a company from a variety of different angles before investing in it.

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May

2023

Option Assignment: Defined and Explained

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing, Terminology | Comments Off

Option assignment happens when the owner of an options contract elects to exercise their puts or calls. That means they wish to trade the underlying security at the strike price which requires the options contract seller to fulfill their obligation.

While relatively few options contracts are ever exercised, options writers must be aware of assignment risk. Options assignment requires buying or selling the underlying security at the strike price.

As with all options trading, it’s important to know and understand all the key risks. American-style options can be exercised at any time before expiration, which means sellers might be faced with option assignment whenever they hold a short position. Option assignment is also more likely as expiration nears.

What Is Option Assignment?

Writers/sellers of option contracts assume the obligation to buy or sell shares to satisfy the terms of the options contract. Buyers/holders of options contracts purchase the option to exercise these options under the terms of the options contract.

Option assignment is the process of matching an exercised option with a writer of an option. In the rules laid out in a basic options trading guide, the individual short an options contract is obligated to fulfill their duty by either purchasing or selling a specific number of shares of the underlying stock should the holder choose to exercise their option.

The option contract owner, also called a holder, has the right but not the obligation to buy (in the case of a call option) or sell (in the case of a put) a predetermined number of shares at a strike price. It is only when the option contract holder elects to exercise, that option assignment happens. The individual short the options must then abide by the contract’s provisions.

How Does Option Assignment Work?

Option assignment works when the seller completes the terms outlined in an options contract after the call or put contract owner chooses to exercise. By selling an option, you issue the buyer the right to own a certain number of shares of stock at a predetermined price in the future. Any option strategy that has a short leg, such as a bull put credit spread, has assignment risk.

Call options offer the owner the right but not the obligation to buy stock while put options give the holder the right but not the obligation to sell shares. The call option seller, on the other hand, would potentially be required to buy stock in order to sell it to the call option owner.

Writers of bond options also face assignment risk.

A Peek Under the Hood

The mechanics of this process can seem unclear since there are so many options contracts traded, and it’s hard to determine who is on the other side of your trade.

Options trade through exchanges, and since they are standardized contracts, the exchange is essentially the counterparty. The entity in charge of facilitating exercises and assignments in the U.S. is the Options Clearing Corporation (OCC). Option assignment rules are followed, and the OCC ensures a fair process.

An options assignment happens when the holder exercises a contract. The OCC then randomly allocates this assignment to brokerage firms that have account holders who are short that contract. The brokerage firms then use their own rules and processes to allocate the assignment to a specific holder.

The two parties to the assignment are not required to be the same two parties that entered into the original options contract.

Can You Know If a Position Will Be Assigned?

According to the Options Industry Council (OIC), it’s hard to know when you will be assigned, as it can happen any time up to expiration for American-style options. Many index options, or index futures options, are European-style however.

It may be helpful to know that just 7% of option holders exercise their right, and that percentage has not budged much over the years, according to the OIC.

Can You Do Anything If a Position Is Assigned?

You must meet your option assignment duties once you are assigned. What’s nice, though, is that many brokers handle the process automatically for you. Traders should be prepared to see their account balances fluctuate when an assignment happens. When trading futures options, you might also see a cost of carry with the underlying futures contracts.

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What Happens After a Position Is Assigned?

A writer facing an options assignment will be notified through their brokerage firm.

A seller of call options must deliver shares at the strike price and in return receives cash. If the seller wrote covered calls — and therefore owns the shares in their account — their brokerage can simply transfer the shares from one account to the other, and the seller will receive the strike price for each sold share.

If the seller sold naked calls, they will be required to buy shares on the open market to provide them to the options holder, but will also receive the strike price per share. If the seller has pursued a combination options strategy, it might be possible to exercise another option to satisfy the terms of the assigned option.

For someone short puts facing option assignment, they are obligated to buy shares at the exercise price from the holder of the option. If the put seller pursued a cash secured put strategy, they will have the cash in their account to make the purchase. If the seller does not have the cash, they will have to deposit sufficient funds or sell account assets to fund the obligatory assignment purchase.

Option Assignment Example

It helps to run through an options assignment example to grasp how the process works.

Let’s say you were bearish or neutral on the price of XYZ stock over the coming 30 days. You also want to take advantage of what you believe to be high implied volatility of call options on that stock.

After analyzing the option Greeks, you decide to sell $100 strike call options while the shares trade at $95. The option premium you collect is $10.

After three weeks, the stock has jumped to $105, and the short calls are worth $6. You are alerted that you now face a call option assignment. While a small percentage of options contracts are exercised, you are among the few who are chosen to be assigned.

To meet the requirements of option assignment, you must deliver shares to the individual who exercised the call option. You can buy shares in the market or, if you own shares and wrote a covered call, your shares might be called away.

For puts, the purchaser of the option sells (or “puts”) shares to the writer by way of a short position.

Option Assignment and Multi-Leg Strategies

Some of the more complex options trading strategies, like those involving many legs, can face more option assignment risks. If just one leg of a broader trade is assigned, the writer must act. That might involve closing the entire strategy or simply adjusting the other legs to manage risk.

Once an option seller’s position is assigned, the trader must meet the contract’s terms to buy or sell shares of the underlying security, regardless of what other legs the writer has active. That is part of the risk of selling options as part of a multi-leg strategy.

What Does Assignment Mean for Individual Investors?

Options assignment is just another risk to be mindful of when selling puts and calls. While there are plenty of upshots to writing options, such as collecting premium, assignment risk is present. It’s important that you check with your brokerage firm to know their option assignment process and cut-off times. Some firms might have significant costs while others might feature option assignment free trading.

The Takeaway

Option assignment happens to writers of contracts when the owner of puts or calls elects to exercise their right. Options sellers are then required to purchase or deliver shares to the individual exercising. The OCC randomly selects sellers through the option assignment process.

Only option sellers face assignment risk, so you can avoid the risk by only being on the long side of contracts.

If you’re ready to try your hand at trading options online, you can set up an Active Invest account and trade trade options from the SoFi mobile app or through the web platform.

And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commissions, however other fees do apply, and members have access to complimentary financial advice from a professional.

With SoFi, user-friendly options trading is finally here.

FAQ

How is option assignment determined?

Option assignment is determined by the OCC which randomly assigns firms that have accounts short options. This only happens once an options contract holder chooses to exercise. While a small portion of options contracts are exercised, traders should understand the risks, particularly as expiration nears, as that is when assignments are more likely.

Are options assigned before or after expiration?

American-style options can be exercised, and thus assigned, any time before expiration. European-style options, however, are only allowed to be exercised during a specific period right before expiration, so options assignment can only happen then. Be sure to know the style of options contract you are selling so that you know your option assignment risk.

What are option assignment fees and how much are they?

Options assignment fees vary by brokerage. These days, trading commissions to fulfill obligations from being short an options contract are generally reasonable. There could be a base options trading fee plus a per contract charge, but some brokers do not have options assignment fees at all.

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