Hi ALL! I was never got assigned always was working with vertical spreads OTM and I just wonder how does assignment works. Is there anybody could explain in detail how does assignment work? For example, I don't know is it legal to be assigned on sold calls/puts that ITM with not in current month but further 2-3 months from now? Thank you.
You can be assigned early on any short option no matter how unlikely it may seem as it is the holder's right. However, early exercise takes place due to specific economic reasons, not just because the option holder wants to screw up the writer. An american-style call will be exercised early is when the stock goes ex-dividend. That is, if the day before the ex-div the cost of carry to expiry plus the price of corresponding put is less than the amount of the dividend then the call will be exercised early. Cost of carry is strike*fed funds rate*days to expiry/360. Although the actual interest rate may be different, the fed funds rate is a good approximation of what pros pay. Also, if you are assigned on a short call going into ex-dividend then you will be responsible for paying the dividend as you'll have a short stock on ex-dividend. An american-style put will be exercised early is if the cost of carry to expiry is more than the price of corresponding call. Early exercise may also take place due to the bid-ask spread, i.e. if the option is trading at parity.
Let's say you set up a spread to cover yourself for the short position and you get assigned. How do you cover that? Just close out the long-option by selling it? Or do you have to exercise the long-option to cover the assignment (and eat the difference)?
If the long side is still OTM then you would definitely sell the long option to capture the remaining time value and close out the stock position in the market. If the option is ITM then again you have to consider how much time value you'll be giving up vs. the benefits of exercising the option (for example, depending on the commission structure and position size, it may be beneficial to exercise rather than sell a long option that is trading around parity).