There are a particular set of rules regarding assignment and exercise of options.  Those rules are generally enforced by the Options Clearing Corporation (OCC).

Remember, with American style options, the holder of the option has the right to exercise that option at any time before the option expires.

What we are concerned with here is only the automatic exercise of option contracts because that process effects cost basis in the underlying stock.  With automatic exercise, generally the OCC will automatically exercise any expiring equity option (call or put) if it is at least $0.01 in-the-money.

What does that mean?

Calls

Long:  If you purchased (BTO) a call on Apple with a strike price of 350 that expires in August of 2011 and Apple closes on expiration Friday at $350.01 or higher, you will automatically be assigned shares of Apple based on the number of calls held.  In other words, if you held 1 contract, you will now purchase 100 shares of Apple at $350 per share.

Short:  If you sold (STO) a call on Apple with a strike price of 350 that expires in August of 2011 and Apple closes on expiration Friday at $350.01 or higher, you will automatically be forced to deliver 100 shares of Apple stock to the holder/buyer of that call option.  If you do not already own the shares (a naked call position) you will have to purchase the shares at the market price when the market opens.  If you already own the shares (a covered call position), 100 of your Apple shares will be delivered to the holder of the call option.

Puts

Long:  If you purchased (BTO) a put on Apple with a strike price of 350 that expires in August of 2011 and Apple closes on expiration Friday at $349.99 or lower, you will automatically be short Apple shares based on the number of puts held.  In other words, if you held 1 contract, you will be short 100 shares of Apple at $350 per share.  You can now “cover” your position by purchasing 100 Apple shares in the market at presumably a price lower than $350.  However, there is the obvious weekend risk associated with being short stock, which is beyond the scope of this discussion and subject to your broker’s rules.

Short:  If you sold (STO) a put on Apple with a strike price of 350 that expires in August of 2011 and Apple closes on expiration Friday at $349.99 or lower, you will automatically be forced to purchase 100 shares of Apple stock from the holder/buyer of that put option.  This is called a naked put position and is a great way to get into a stock at a lower price, assuming you have the cash in your account to facilitate the purchase - a cash-secured naked put.

What are the tax implications of automatic assignment or exercise?

Contrary to some opinions, options CAN impact the cost basis of your underlying stock positions.  So how can that happen if they are separate securities?  Let’s look at some examples:

Example 1 - Assigned Puts:

In December 2009 AMR (the parent company of American Airlines) is trading at $8.25 per share.  You believe it could go higher but you don’t want to purchase the stock at the current price.  You sell 10 Jan 2010 8 puts (naked, but cash secured) for $0.50 per contract and bring in $500 premium (ignoring commissions).  At January expiration, AMR has dropped to $7.90 per share and you are assigned the stock for $8.00.  Your basis in those shares is not the $8.00 purchase price but $7.50 ($8.00 strike price minus the $0.50 received from selling the put).  Also, as described above, the premium for selling that put in December is not income in that year but decreases the cost basis in the stock purchased in January, which is also when the holding period begins.

What happens to the put originally sold?  It is NOT reported on your tax return!!  The underlying stock prices “absorbs” the premium into its new cost basis.

Essentially, this treatment has the potential to turn what would have been a short-term capital gain into a long-term gain.  If the assigned shares are held more than one year, the premium received from the sale of the put is now buried in the basis of the stock which is subject to long-term capital gain treatment.

Example 2 - Exercised Calls:

In March 2011 McDonalds (MCD) is trading around $75.  You believe it has the potential to go higher by the end of 2011 and buy to open (BTO) a call option on MCD with a strike price of 80 and an expiration in May 2011.  On the May 2011 expiration date, MCD closes at $82.33 and you are assigned shares.  The option originally cost $0.75 so your basis in MCD is now $80.75 per share ($80 strike price + $0.75 paid for the call option).

What happens to the call originally purchased?  It is NOT reported on your tax return!!  As in the previous example, your basis for gain or loss has been increased by the price paid for the call.

Download the following Table as an Adobe pdf by clicking here.

Example 3 - Exercised Put

In June 2011 Netflix (NFLX) is trading around $300 but you believe it is overpriced.  You purchase a put with a strike price of 280 for the August expiration cycle.  NFLX closes at $205.21 on expiration Friday and you are exercised.  You are now short 100 shares of NFLX which you sold for $280.  Assume you paid $13.60 for the put and you buy to cover your short sale for $210 when the market opens.  Your basis for gain or loss is $210 and your net proceeds from the sale are $266.40 ($280 strike - $13.60 cost of the put) so your gain is $56.40 per share or $5,640.

Example 4 - Assigned Call

In June 2009 you purchase Priceline (PCLN) for $110 and sell an August 2009 130 call for $2.25.  The closing price on the August 2009 expiration day is $153.36 and your shares are assigned at $130 - you forego the gain from $130 to $153.36.  Your basis for gain or loss is $110 and the proceeds from the sale are $132.25 ($130 strike price + $2.25 received for the call).

Obviously, however, this treatment will not agree to the gross proceeds on Form 1099B.  You will achieve the same result by reporting these two transactions separately.  This treatment is illustrated, in part, with the video on the Apple covered call adjusted into a collar, which you can view here or on the section explaining how to report Trading Strategies.