Broken Legged Option Strategy Trading

Discussion in 'Strategy Development' started by mydann, Jun 1, 2006.

  1. mydann


    I am planning to start option strategy trading soon. But the option exercise assignment bothers me a lot. I can't put the option assignment into my strategy trading model. Once the option gets assigned, most likely my broker will liquidate my account. Even if the broker does not liquidate my account when I have enough fund/margin, the strategy trading model is with broken legs and won't be able to work properly.

    As a non-full time trader, I don't monitor the account every day. The unexpected option exercise assignment may ruin all of the profit because the strategy trading usually has small margin. Do you have any experience or idea what to do here?

    I heard that the assignment would be 1%. Is 1% of the option orders or 1% of the option contracts? If one of the option order gets assgined, will all contracts of the order be assigned or possibly partially assigned? At what circustance the order will have better chance to be assigned? Thanks for sharing your story.

    For a big strategy, it may involves dozens of orders. Let's say 50 spreads and 2 months holding. If each order has average 10 contracts, it would be 1000 contracts in two months and 600 orders (6000 contracts) in a year. If assignment is 1% then the assignment is almost unavoidable. (There is no big difference when there are half of the orders are option shorts).

    If I don't have any good solutions, the only thing I can do is leaving the US options along and dealing with Euroupean options instead.

    Appreciate your idea and inputs.
  2. Use a european index and you eliminate any early exercise.
  3. white17


    It sounds like you are asking about early assignment rather than assignment at expiration. If thats correct, then thats where the 1% is coming from. I don't know the exact percentage but it is quite low. Don't worry about it. Usually if the price of the stock is less than the strike price plus the bid price on the contract you won't need to worry about early asignment.
  4. MTE


    I presume you're talking about American-style options and European-style options and not literally US, Euro options. So I suggest you clear that up before proceeding.

    Assignment doesn't happen for no good reason. Generally, an American-style call holder will not exercise early unless the option is ITM and the stock pays a dividend. The key is the put-call parity relationship. For puts you wouldn't exercise until the last dividend is paid and then again the put-call parity matters, i.e. depends on the price of call vs. the cost of carry. I'll leave that for you to explore.

    So the risk of early assignment really depends on the situation and the strategy you use.
  5. mydann


    Thanks for correction on American-style options and European-style options.

    You are right I am talking about the early assignment. For the reason of dividend day, it is avoidable if it is planned well. And most of the stocks I am dealing with don't pay dividend.:)

    For stock options such GOOG, if I buy ATM spread and hold it two months, one of leg will be deep ITM at some point for sure. Look the GOOG option expired at Jun today, early assginment is better than selling the long option if call option is deeper than $100 ITM or put option is deeper than $50 ITM (current price is at $380). I suspect that the closer the option expiration is, the more chance to get early assignment if the option short is deep ITM.

    If I hold the put GOOG Jun 430 which was bought two month ago and wait for selling it at the epxiration day, the possibility of getting early assignment would be very high, right? Becuase it "loses" money if option is sold at the market than early assignment.

    Is there anyone using American style option as strategy trading? How do you deal with the early assignment if it happens to you?
    Appreciate for your sharing the experience.
  6. MTE


    The only reason someone would exercise a call early is if they can't sell it for parity due to the bid ask spread and thus exercising it makes sense. With dividends it is fairly simple, if the price of corresponding put plus the cost of carry on the stock to expiry is less than the dividend then the call will be assigned.

    Cost of carry= strike*fed funds rate*days to exp./360

    If the assignment should happen then depending on your outlook you may either hold it or close out, but then again, i you said somehting about automatic trading system....I'm a discretionary trader.
  7. vjay


    If I read your latest posts correctly, it seems that you are a buyer of the option spreads. You will not be assigned anything
    until you as the owner of the options decide to exercise.

    Now, if you're short selling the options, then you are at risk for an early assignment
  8. mydann


    Here are quotes from 888options:

    Q: How many options expire unexercised? How many are exercised?

    A: According to OCC statistics for year 2005 (for activity in customer and firm accounts), the breakdown is as follows:

    Closing Sales - 48%
    Exercised - 17%
    Unexercised at Expiration - 35%

    So, in 2005, 35% of all options positions in customer and firm accounts expired unexercised; 17% of these positions were
    exercised; and 48% of these positions were closed out through sales

    That means the the exercise chance are very high. When I have 10 vertical spreads in hands and deep ITM, it is almost sure that the option will be early assigned if there is early assignment. The early assignment is fine with spread trading. But the margin call coming from it is too bad.

    Does anyone know how the magin requirement is calculated for spread such as vertical spread or time spread? Let's say I have long GOOG Jun PUT @ 450 & short GOOG Jun PUT @430. To my knowledge, at any price of GOOG, my account will always be positive (larger or eqaul zero) whether or not I get an early assignment. My broker will have no any risk if I haven't borrow any margin to create the spread.

    If I get an early assignment @390, my position becomes:
    long GOOG Jun Put @450 (worth 60x100=6000)
    long GOOG (worth 390x100=39000)
    debt 430x100=43000
    My net balance is 2000. Will I still get the margin call while the broker has no risk at all (as mentioned above)?

  9. mydann, those statistics don't convey a good example of early assignment.

    as many people have already said, there really is no point to anyone exercising early unless it is because of a dividend. this is because the premium in the open market is almost always more than what you get from exercising the option. you obviously don't have to worry about this with GOOG.

    as far as margin requirements, you are establishing a debit spread, so no, there is no risk to your firm. you are financing your long put by selling a lower put, and giving up that potential profit. if you get assigned on your short put because it is so far in the money, you more than cover that by however much your long put is in the money (20 points in your example). this is assuming you assign your long option of course. otherwise, you need to have the funds to cover the stock that was just put to you or you will be put into a fed call. there IS risk to your firm for that.

    to put the option assignment into your trading model, assume 20 points max you can receive from your spread, minus your debit.

    it sounds like you're more concerned with selling spreads and being assigned on those. is that correct?
  10. mydann


    Thanks for the reply, spreadgod. You must be good at spread.:)

    When I constructed my strategy trading on options, I haven't incude the early assignment into my model because somewhere I have learned it is less than 1% chance. Later I searched around the web and figured out that the option exercise percentage (I don't think they are all early exercise) are pretty high at 27%.

    My trading model includes bunch of time spreads, vertical spreads, dignol spreads and butterfly spreads. Basically they are all long spreads and have limited risk for me. Now I have learned the early assignment may not be able to avoid in my model and I have modified the model to accept the early assignment as a fact. The concern for me now is not the early assignment any more. My major concern now is to avoid early liquidation when assignment does happen to my model.

    There are three ways I can see when an early assignment happens:
    1> Early liquidation. It does not matter it is done by me or my broker. It breaks the model and I may lose big money.
    2> Spread repair. It means to close the assignment and short the option leg again. But it is voluntary to have another early assignment if the early assignment is not caused by dividend and is caused by the loser of deep ITM.
    3> Keep the assignment. It works for my current model. My concern is how to keep the margin of my account healthy.

    After an early assignment, a spread becomes either protective put or protective call.

    When a spread becomes protective put because of early assignment, I owe big debt to my broker to have the assigned security and most likely expect to receive margin call. For GOOG, 1 contract is ~40K. That would be too huge for me.

    When a spread becomes protective call because of early assignment, I receive big cash on the security I short. It may OK to some brokers as margin requirement. I will check it out.

    Please share your story on how many early assignments you got, how many times your broker failed to contact you, how many times the broker liquidate for you and how you have dealt it yourself. Appreciate any input.

    BTW, my model has about 10+ spreads. It costs $400+ if I do it through Ameritrade with 1 contract (create the spreads/close the spreads). The commission is the the killer. ThinkOrSwim is close. I am thinking about IB now. It costs $40+, it is much nicer.:p Any recommendations?

    Thank you for reading.
    #10     Jun 7, 2006