Exercise, Assignment and Spreads

Posted by Pete Stolcers on June 9

Option Trading Question

Today Rick W. asks, “I don’t understand what I’m supposed to do when I have a spread and I get assigned on one leg of the trade.”

Option Trading Answer

This is an involved piece. First let me define two terms. Exercise is what the buyer of an option does. They use their right to buy or sell a stock at a specific price. Assignment is what happens to the seller of an option when they are forced to buy a stock or sell a stock at a certain price. If you are long an option you have rights, if you are short an option, you have an obligation.

Let’s say that you are short the 50 - 45 put credit spread and the stock (ABC) is trading at $43 - ouch. It doesn’t matter what you sold it for, this can’t be a good trade. If the 50 puts are trading for $7 (parity) you run the risk of being assigned. If the traders who are long the puts decide to exercise their right to sell the stock at $50, the Options Clearing Corporation (OCC) determines which firms will be assigned and each brokerage firm has a standardized lottery process to determine how the assignment will be allocated across the accounts. As long as the 50 puts carry some premium, this risk is minimal. The reason is simple, the owner of the puts can get more by selling them in the open market.

You come in one morning and you are long ABC stock via overnight assignment of the $50 puts. You have three choices. One choice is to sell the stock and sell the put again. Bad move. Never do this. The options are already trading under parity and now that the option is in play, you will probably get assigned again. The second choice is to exercise the 45 puts that you are long. This action allows you to sell an equal number of shares that you are long. If you were assigned on 5 puts and you are long 500 shares, you would exercise 5 of the 45 puts. Now you are “flat” the stock and if you do it the same day, you are exempt from having to put up the margin for the long stock (rule: same day substitution). This action makes sense if the stock is trading below $45. The third choice is to simply sell the stock in the open market if it is trading above $45. If it is done the same day, it also qualifies for the margin exemption.

If the risk scares you, you can always place an order to buy the spread in for $5. That is the max that it can ever be worth and you should not pay more than that no matter what the screen (bid/ask) shows. I do not advocate doing this because in essence you are giving someone a free call. They sell the spread for $5, the most it can be worth. If the stock reverses, they will participate in the rally - WITHOUT TAKING ANY RISK.

The risks and approach are much different for cash settled products like the OEX. That might be a future article. A stock that is closing right at the strike of the cheap leg of a spread on expiration Friday also creates a problem that will be covered in the future.

If you are having issues with a position this expiration, post a comment and let’s take a look.

Option Trading Comments

On 12/19, Andy McArthur said:
If you’re assigned last minute though can the broker automatically exercise the other leg of the spread or is it possible for time to run out on you?
On 12/21, A. Akber said:
Similar Question to Andy’s.
If I am long (abc @ 45) and short (abc @ 50) and abc is at 53 at 3 pm, I know the short will be assigned. Do I need to exercise the short before market is closed or is it exercised automatically over the weekend?
On 12/21, Pete Stolcers said:
Any option that is $.05 ITM will be auto excercised. No action required. It’s the options that close right at the money that require attention.
On 01/25, Cozzie Motto said:
I bought a covered call on 500 sh of VLO with strike price of $50 and received 12.70 sh up front to open the call. I know that the share can be called away when they go to $50 or more. It is doubtful that the shares will be called away until they go above $62.70. because that is the purchaser’s break even point. At what point or what event will cause the purchaser to call my shares? Is it going to be the first major pull-back above the break even point? What usually happens. My covered call expires in Jan. 2010. What is my best strategy at this point.
On 01/28, Pete Stolcers said:
When the options go in the money and trade below their intrinsic value, you run the risk of assignment. That usually does not happen until they are front month. In the Categories section of my blog, I have articles written about assignment. You can also used the search feature to find related articles. They will give you a detailed answer.
On 02/14, Doug Ankele said:
Hello,

When is a good time to sell to close? Obviously,as much over the strike price as possible, but does the value of an option decrease after hitting the strike price as you get closer to the expiration date? I’ve heard something about time value.

Thanks,

Doug
On 02/15, Pete Stolcers said:
Doug -

As long as the stock is going up, the call option will increase in value. The time component will be a smaller portion of the overall option price because it is picking up actual value (intrinsic value) as is crosses over the strike price. For instance, an at-the-money (ATM) option that is trading for $2.00 is all time premium. Once it is $2.00 in-the-money (ITM), it might be trading for $3.50. The option has intrinsic value of $2.00 and the time component is only $1.50. The time component has gone down, but the total price of the option has gone up. Don’t get hung-up on this concept.

As for the trade, get out when the stock stops doing what you expected. If the market is up and the stock is down, that is a great sign to take profits on a call. If you have big gains and the stock stalls, start taking profits. If the market is flat and the stock is surging higher, stick with it.
On 03/11, Charles said:
What could be the possible outcomes for the following equity option trade…

long VLO
short VLO

Thanks in advance.

Charles
On 04/03, Chris said:
Can i find ATM options in the market?i am interested of making straddle strategy
On 04/03, Pete Stolcers said:
I am not a big fan of straddles, but there are times when they work well. Due to the naked margin requirements and the risk, straddles are buy side only strategy.

They are most effective during low volatility environments. You can buy cheap volatility and search for surprise movements - like earnings. Right now, the IVs are high and it is a tough way to make money.

If you are going to attempt it, you have to find a system that identifies potential explosive moves. I know a few traders who use to search for Board of Directors Meetings with the idea that a big announcement might be forth comming. It worked, but the last time I heard, that system played out and Market Maker firms adjusted the IVs ahead of the meeting. I also know traders who buy straddles ahead of an FDA hearing on one trick pony biotech firms. You will pay through the nose for that straddle, but the moves are big. The point is, have a system.

I wrote and article on straddles. Please use the search feature to find the post.
On 05/03, sen said:
I buy jun 35 and sell may 35 calls for GE establishing a calendar spread. Let us say the stock hits 36 and the buyer of may 35 calls decides to exercise to option how does the process go? I am new to spread trading and i would like to know the risks associated with the same.
On 05/05, G.N. said:
"I bought a covered call on 500 sh of VLO with strike price of $50 and received 12.70 sh up front to open the call. I know that the share can be called away when they go to $50 or more. It is doubtful that the shares will be called away until they go above $62.70. because that is the purchaser’s break even point. At what point or what event will cause the purchaser to call my shares?”

Pete,

to confirm Cozzie Motto’s comment above; the reason why chances are low he’d get assigned on his short $50 calls before expiry if they’re ITM, regardless of being at/above 62.70 or between 50 and 62.70 is not because 62.70 is the purchaser’s B/E point - assignment is a lottery process and Cozzie has no idea how much his would-be assignor paid for his long $50 calls, perhaps his cost basis was much lower (12.70 has no bearing on anyone except the premium receiver.)

The reason is simply that exercising an ITM contract before expiry results in loss of time value - the purchaser can sell his long $50’s for more than intrinsic value in the market. (The more technical reason is that it never makes sense to exercise an ITM option before expiry unless receiving dividend from being long stock can cover the long stock’s cost of carry in case of exercising long ITM call or, in case of exercising long ITM put, the interest rebate received from stock short sale can offset dividends now owed from being short stock.)

Am I correct in this?

Thanks,
G.N.
On 05/05, Pete Stolcers said:
G.N. is correct. Assignment comes down to simple math. The $12.70 credit has nothing to do with option assignment. If the stock is $1.00 in-the-money and the stock options are trading @ $.95, the holder of the stock option will exercise his right and sell the stock in the open market for a nickle more than he could get by selling the option in the open market. In this scenario, someone will get assigned and it might be you. Conversely, if the option is trading at $1.20 with the stock $1.00 ITM, there is time premium and the holder of the option will not exercise, he will sell the call option in the open market.
On 05/05, Pete Stolcers said:
Hi Sen,

The process goes like this: you come in the next day and you are short GE (via assignment) and long the June 35 calls. At that juncture you have one day (same day substitution) to buy the stock and avoid having to put up the margin requirement for the short stock position. If you did that, you would be flat the stock and long the June 35 calls. You can either hold the options if you think the stock will head higher or sell them to unwind the position.

As a side note, if the options ever go deep in the money, and they are trading at parity, you can simply exercise the June 35 calls (you were short stock at $35 and now you willbe buying stock at $35) and you will be completely out of the position. Your loss will be the debit you paid for the calendar spread. As long as the June options have time premium, the first process should be used to unwind the option trade.
On 05/14, edward said:
I am long Iron condor position- may 2008 RUT670/690/740/760. RUT IS @742-743.My upper breakeven point is 742.50. I was considering closing the trade but the 740 call is about $6.00.
Question- if RUT stays at this level on expiration, all the other legs except the 740 will expire worthless, will my acct. be debited the amt that the 740 is in the money? In this case $2-3 per share since it is a cash settled option or are my at risk of futher losses if RUT CLOSES @ 742.50.
On 05/15, G.N. said:
RE: Sen’s question

The first process (buying the stock, avoiding margin via same day substitution, keeping the long June 35 leg untouched in case stock moves higher) assumes that there’re sufficient funds to cover the transaction.

Too often the retail investor with an undercapitalized account, when faced with the sticky situation of assignment, is lulled by the false sense of comfort thinking they can always just exercise the long calendar leg to obtain stock required for deliverance, resulting in loss of time value on that long option leg, plus incurring extra transaction commission.
On 05/15, Pete Stolcers said:
To G.N.’s point, it is usually better to buy the stock and sell the calls in the open market to capture the time premium in the options.

If the June options are deep in the money and they are trading at parity, just exercise them to exit the position.
On 05/15, Pete Stolcers said:
Hi Edward,

You say you are long the iron condor. That would imply you are long the closer to the money options.

Next, you ask if you will be debited by the amount that the RUT is across the 740 strike at expiration. The two statements conflict.

When you sell the closer to the money strikes, you are short the iron condor.

Either way, if you are long the 740 calls, they will be auto-exercised for cash at expiration. If you are short the 740 calls, you will be auto-assigned and debited the abount they are in the money.
On 05/15, Edward said:
Sorry for that- I am actually short the 740 calls and long the 760 calls (short the iron condor) but I get your point.
Thanks for your reply.
BTW, great and very informative site.
On 05/15, Pete Stolcers said:
Not a prioblem, I figured as much. I’m not a big fan of iron condors, I hope they are working out for you.

Please spread the word about my blog. I don’t advertise and traffic is my only motivation.

Exercise, Assignment and Spreads

Option Trading Question

Option Trading Answer

Option Trading Comments

Leave a comment or question on options trading

Categories

Resources

Option Trading Q & A

Free Option Trading Event