Early assignment

Discussion in 'Options' started by Neoxx, Sep 8, 2006.

  1. Neoxx

    Neoxx

    Still relatively new to options (nine months), and discovering my trading style, find I'm increasingly leaning towards (just) ITM credit spreads to trade single direct equity moves. I prefer them over their debit counterparts simply because of the opportunity to leg out if the trade goes against me.

    I realise I'm at risk of early assignment on these positions, but what are the variables that determine this risk?

    ITMness of short strike?
    Time to expiry?
    Dividend date?
    Other factors?
    All of the above?

    Aside from minimising my holding period, and avoiding new positions in expiry week, anything else I can do to insulate myself against this occurence?

    Thanks,
    Neoxx
     
  2. Beware OEX, there are all sorts of issues with being assigned early that have nothing to do with the list you mentioned.

    As an addendum to that warning, beware cash-settled instruments. An early exercise leaves you with a more risky position than you'd expect. On non-cash settled instruments, this is less of an issue.

    (As an example, put together a box and then assign yourself a short leg that's cash settled and compare it to an assignment for an underlying-settled instrument)
     
  3. In summary, the risk of assignment is high when there is very little, or no, extrinsic value in your short leg.
    daddy's boy
     
  4. Neoxx

    Neoxx

    Thanks.
     
  5. MTE

    MTE

    I don't know why exactly you prefer ITM credit spreads when OTM debit spreads are exactly the same with no early exercise risk, but let's put that aside.

    As others have pointed out, the less time value there is the greater the risk. Time value decreases with the option moving more ITM and decreasing time to expiry.

    Dividends are extremely impotant for short ITM calls. If the amount of the dividend is more than price of corresponding put plus the cost of carry to expiry then the short call will be assigned on the day before the ex-dividend date, which would leave you with a short stock position on ex-dividend and you would be responsible for the dividend.

    The dividends are not a problem for puts. In fact, a put holder will generally not exercise an ITM put until the last dividend is paid. Now, if the cost of carry is more than the price of corresponding call then the put will be assigned.
     
  6. Hi MTE
    Sounds a bit complex to calculate. Why not just work out the short call's extrinsic value and if it's equal to or less than the dividend, early exercise is virtually guaranteed? The maths seems a little easier than "corresponding put, cost of carry ..."?
    No?
    Best
    daddy's boy
     
  7. Neoxx

    Neoxx

    With credit spreads, if the underlying goes against me I can leg out without holding naked shorts.
     
  8. ???
    Surely you can leg out of a debit spread also if the underlying moves against you. There really is no difference from the risk reward point of view of debit vs equivalent credit vertical, as MTE has already pointed out.
    daddy's boy
     
  9. 2 words - pin risk!
     
  10. If the underlying moves against you then buying back the short leg in a credit spread leaves you with a long leg that benefits from the continued move against the original position.

    Buying back the short leg in a debit spread leaves you with a long leg that is hurt by the continued move against the original position.

    However, what the OP is perhaps not aware of or perhaps wants to avoid is that when you have a debit spread, legging into a box is equivalent to legging out of a credit spread in the manner described above.

    2 cents.

    MoMoney.
     
    #10     Sep 10, 2006