Hi All, I'm relatively new to options and have been reading the various 'Options' threads with great interest. Amongst other things, I've learned that a vertical debit spread can bring with it the risk of a margin call should the short side temporarily be more valuable than the long (http://www.elitetrader.com/vb/showt...t=vertical and spread and margin&pagenumber=1). So, before I even think of trading, I had a couple questions of my own: 1) How often does the sort of temporary pricing imbalance mentioned in the cited thread actually occur? Is this relatively common, and does it typically trigger a margin call no matter the broker you use? 2) Assume that I have a credit vertical call spread of 10 contracts on the ever-popular company XYZ: Sell Mar 50 Call @2.50 Buy Mar 55 Call @1.50 Net credit of $1.00, which is applied to the $5 maintenance margin requirement for a net maintenance requirement of $4000. Okay, assume underlying moves to 52 and I'm assigned (before expiration) on the short 50. Now I have a couple of choices: 1) Go out into the market and buy the shares to cover the short stock position. Hold the 55 calls, or sell them for whatever time premium I can get. Or... 2) Exercise the 55 calls. Now, you may think, why on earth would you exercise the long calls when you are going to pay $3 above current share price? And thus my question: In choice (1) I must have sufficient cash to be able to purchase the stock to close my short position. However--if I understand this correctly--if I exercise my long calls as in choice (2) within one business day of assignment, I need not post additional margin, and the long call exercise offsets the short shares, netting a loss of $3/share, to be sure, but not requiring me to cough up $52,000 in cash to buy the shares outright. Is this a correct summation, and is this 'same day substitution'? I realize that this is probably pathetically simple stuff to you, but as a newbie I want to make sure I understand what my potential choices are and what costs are associated with each. Thanks in advance for any insights you can offer!
If there's any time premium remaining in your short 50 calls, you're unlikely to be assigned. Exercising the long 55 calls to buy the stock $3 above market is insane. Don't. It's a $3 haircut. What you do depends on your margin and your outlook for XYZ until expiry. If you have the margin and you believe the stock is going to head down you can hold the call protected short stock position. If you don't have the margin and want out, just cover the short shares and sell the long calls for whatever salvage value there is. If only pennies, hang on to them as a lottery ticket. Last possibility is sell something that has premium, creating another spread.
anything strategy involved in short sale whether they looks they can cancel each other or in reality it does, there are margin requirements for those short sale (wether the underlying or call or put). so I never use any strategy involved in short sale. i just plain vanilla to long, whether stocks or its call or its put, or simple spread. i do not undersatnd why people need put down a margin. option itself gives people the maximum leverage, the margin requirement greatly dimishes the leverage power. the only usage of option is its leverage, not its fancy strategies! I call those people stupid, people use fancy stuff or complicated things does not mean they are smart, on the contrary, they are stupid. the sharper the knife, the quicker the cutting. common sense.
I had some of the same concerns, and this is what I've learned. Early exercise on option credit spreads is real, although uncommon. First off, when you are exercised, CONGRATULATIONS. That means that YOU have gained all of the time premium which existed in the option when you sold it. Second, in order to exercise, the exerciser must hand you $5000 ($50 for each share in the contract). (If we are talking about 10 contracts, then you would be handed $50,000). When this first happened to me, I did not realize that I would get the cash upfront for early exercise. Not only that, but I was given a trading day in which to take action. You can take that $50000, plus $2000 from your account, and purchase the shares for delivery. You have the money in your account because you have $4000 in the account as margin, which is no longer needed to be maintained because you are no longer short any options. Also, there is no need to exercise your long option. You can sell your long option for a profit, perhaps, or you can write another option covered by the $55 long option. Nothing stops you from doing that. If you run through the scenarios and profit and loss, you will see that early exercise is not a bad thing. One caveat, it does expose you to market risk for the overnight gap and also market movement before you purchase the offsetting shares. It is not hard to minimize the risk of early exercise, if you are willing to make adjustments. For example, let's assume that the market price of the $50 call option was $2.00 or $2.05 on the day before exercise, when the stock was at $52. You already captured the $1.00 of time premium in the stock. Unless there is a buyout offer at $52.00 or something like that, the next month's call option at $50.00 should be trading at $2.30 (or $2.20 or $3.00, obviously depending on the stock's volatility), more than the front month's price. So BTC the short front, and sell the next month's option for next credit of $.25 per contract. This is called rolling out the option. It is worth thinking about, but it really depends on the underlying. Option credit spreads are all about risk management, and as such, generally it is safer to trade with the trend rather than against the trend. GL and safe trading!
R, thanks for explaining the mechanics on early exercise and I assume the mechanics are the same for an expiration exercise except you can get up until Tuesday sometimes? Now I wonder how an early assignment of a put spread would work? Same stock but I have a $45 strike put and a $40 strike put and the stock price moves down and we are in expiration week. Thanks.