In order to put some numbers on Nazzdack's idea, I did a little bit of analysis, see below. I did this using the OptionsXpress "pricer" tool, because it was handy and easy to use. It's pretty inaccurate for way OTM options, but that doesn't matter here. These start way OTM, but we can get that price from the bid/ask. Then as the underlying drops, they become ITM, and pricer works OK. One other thing about pricer, it doesn't do futures options, so I used puts on IWM. Just multiply everything by 10 to get the corresponding numbers for the ER mini, more or less. OK, a 65 strike March IWM put has an ask of .37 now, with 23 days left and volatility of 26%. If IWM crashes overnight to 64 (10% drop), then the put goes to $2.20, assuming constant volatility. Of course, volatility is not constant. I'm not sure what the volatility would be, so I tried both 50% and 70%. (Just for comparison, in the 1987 crash OEX had a volatility of over 80%, and we all know SPX is less volatile than RUT) So, at 50% volatility and IWM=64, the put is now worth $3.72. And at 70% vol, it goes to $4.99. Keep in mind that the intrinsic part of this is only $1.00! So I think Nazz is absolutely right. If you own a put worth $5.00, are you gonna exercise early and only get $1.00 worth of value out of it? I doubt it, you'll probably just sell it and get the full value. So that removes the worry about an immediate exercise -- I didn't realize the numbers were quite this large. Of course, come expiry, if the put is still ITM, someone is going to exercise it, so you have to be ready and plan for that, maybe by buying it back before, on a bounce a few days after the crash. But you have some time to worry about that and how to resolve it. However, it looks to me like you could incur some costs getting this worked out, if that situation happens. Say the bounce doesn't happen, or the underlying falls further. Couldn't you be stuck for the difference between the 650 put you're short and one of the 630's you're long, worst case? Or you could buy the put back, paying for part of it by selling your second 630 put that you're long. But if the put costs 50 points to buy, that's an expensive purchase. So, I'm still undecided about this. It seems to me that buying a straight put from the gitgo entails less risk, and maybe less cost.
What do you mean: "wow...never knew that!"!? Did you think that shorting an option wouldn't have any potential assignment consequences? SPY and IWM are very liquid (index ETFs) as are SPX and RUT.
No I did not! What I did not know was that, if I sell a naked put the original buyer can and may exercise it prior to expiry?!!! can they? I thought even if they decided to do so then the clearing will take care of it without disrupting my situation. Now having said that, obviously if one does go to expiry then of course will be responsible for all settlement and assignment consequences. thanks for the heads up. BTW, what are the consequences and costs involved if the buyer of the option decides to exercise prior to expiration and why and with what incentives would a buyer want to do that and how often does that happen? thanks, nice informative thread.
Nazz..., great info thanks. again never had looked at it this way that extrinsic value of the opposite side can be taken into considerations for value calculations of the DITM side.
No, you are not "linked" to the original buyer, but any buyer can exercise and the assignment is random (well, the process has several steps, but overall it is random), so you may be the one assigned. Do a search on "early exercise" here on ET as well as Google. There are tons of info on it. To give you a short answer, an American-style call is usually exercised early if it is ITM and the stock goes ex-dividend. An American-style put is exercised early if it is ITM and due to the cost of carry. In other words, the reason for early exercise is usually an economic one, not some weird wacky... Here's a link to an explanation on the ASX website.
again to help us understand better and BTW thanks for all your help so far. Then under the situation below, if the 715 call had a premium of 30 when price at 640, then the 715 put is worth(roughly) 105, did I get that right? any good readZ(available on line(I'm presently overseas, can't buy books)) on the extrinsic value calculation of the options? as to how does volatility and time value should measure into it? thanks
Ahh, OK. now that makes more sense for the assignment to be random(still had no idea this could happen and it is great to know and beware of it). thanks for the link.
regarding the quote below about the Ex-dividend issue, now this would only apply to options on stocks and not apply to the index options right? "American-style call is usually exercised early if it is ITM and the stock goes ex-dividend. "