What to do if you're assigned early on a short option in a multi-leg strategy

OddTrader · Sep 17, 2016

Discussing/Sharing about your comments/experiences would be appreciated!

What to do if you're assigned early on a short option in a multi-leg strategy

http://www.optionsplaybook.com/managing-positions/early-options-exercise/

Early assignment on a short option in a multi-leg strategy can really pull a leg out from under your play. If this happens, there’s no hard-and-fast rule on what to do. Sometimes you’ll want to exercise any long options and sometimes you’ll just want to close your entire position. But it’s always a good idea to keep a swear jar and some small bills near your computer just in case.

If you are assigned early on a multi-leg strategy, feel free to give us a call at TradeKing and we’ll help you handle it in the most opportune way.
More...

OddTrader · Sep 17, 2016

Accredited advisers

http://www.asx.com.au/documents/res...rategies.pdf?advancing_options_course_04_text

To advise on most of the strategies covered in this course, your adviser must be a Level 2 Accredited Derivatives Adviser (ADA).

A Level 1 ADA may advise on:
• buying options, and
• writing fully covered calls.

An adviser must be accredited at Level 2 to advise on:
• writing options (other than covered calls), and
• multi-legged strategies involving written options.

Ask your adviser whether they have the appropriate accreditation for the strategy you are considering.
More...

OddTrader · Sep 17, 2016

Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies.

http://community.tradeking.com/memb...4-option-exercise-and-early-assignment-part-4

This week we discuss assignment risk to spreads, with a special emphasis on calendar spreads. It can unfortunately be too common, to tee up what you hope to be the perfect spread, only to be exercised against, lose the short leg – and not know what hit you, or what to do next. Sound familiar?

The tough fact here remains: if you’re short an option, you are not in control of when you may be assigned – the option buyer is. We’ll run through some scenarios that may help you weigh the odds of your chance of getting assigned, but keep in mind that people aren’t always rational. Option buyers will occasionally exercise in scenarios where it makes absolutely no sense to do so, and there’s really nothing you can do to eliminate that risk entirely. What you can do is what we’ll discuss today: tee up spreads intelligently, with an awareness of the possibility of early assignment, and review a considered plan for how you’ll react if it does, indeed, happen to you.

Remember: calls and puts are not equally at risk for assignment

You may recall from previous posts that calls and puts pose different degrees of assignment risk. In general, puts are more likely to be assigned early than calls, simply because of human nature. In brief: call exercise requires the call owner to buy stock, using cash to do so, whereas put exercise means the owner must sell stock, putting cash into the account. Receiving cash now is often more appealing to investors than spending cash now, largely explaining why puts are more likely to be assigned early than calls.

There is one important exception to this rule: when there’s an upcoming dividend, it may entice many call owners to exercise in order to capture it. Call owners aren’t entitled to the dividend unless they become stock shareholders in time. For this reason, many call owners might exercise a call before the ex-dividend date to become the shareholder of record and receive the dividend. This same dividend reduces the chance a put owner would exercise just prior to the ex-dividend date. If a put owner exercises and does not own the stock she or he would be short the stock and then be obligated to pay the dividend.

Out of balance

I’ll be focusing on long calendar spreads below, the early assignment risks are exaggerated because the strategy involves different expiration dates for the options. Keep in mind that similar early assignment risks and recovery strategies apply to vertical spreads, too.

When constructed with calls, long calendar spreads are often billed as a low-risk strategy. Here’s how they’re built in a nutshell: You sell a front-month call on XYZ at the 50 strike, say, and then buy a back-month call on the same underlying, also at the 50 strike. Now you have an obligation to sell stock (if necessary) in the front-month period, balanced by the right to buy stock (if you choose) at the same strike in the back-month period. It all sounds like it’s in perfect balance, and it can be – but it’s not guaranteed to be. The trade is usually done for a net debit, and many textbooks will tell you the most you can lose is that debit amount – which is not entirely true for American-style options that can exercise at any time before expiration. Currently all stock options trading in the U.S. trade American-style, which means they all carry this early assignment risk.

To paint this picture, let’s imagine that stock pays a big dividend - 50 cents - a week before the front-month option contract’s expiration date. Your short call might get assigned, because the call owner is enticed into capturing that dividend and the cost of carrying the stock is less than the time premium left in the call. (Learn more about cost-to-carry considerations in my previous post.) If that happens you’d have to supply that stock at 50 to the call owner (leaving you short the stock before the ex-dividend date). If you’re short stock you’d also have to pay that 50-cent dividend to the owner of the stock you shorted. Suddenly the balance of your calendar spread is out-of-whack: you basically sold the stock for 49.50, and have the right to buy it via the back-month option at 50. That 50-cent risk in the middle was created by the early assignment of the short call.

(Another annoying thing for traders who’ve never been short stock around a dividend before is that payment of the dividend to the stock owner is not instant. A month or more can go by after the ex-dividend date before you see that dividend debit you paid to the shareholder hit your account. By then you don’t even have the short stock position, so you’re left wondering: “What’s this new debit in my account?” Well, it might be cold comfort – but at least now you’ll understand why.)

Many traders’ first urge is filled with either panic or vindictiveness: exercise the back-month and to cover the short position caused by the assignment. Well, that might give you some momentary emotional satisfaction, but it’s usually not a particularly smart move, since exercising the back-month means you’ll lose the extended time-premium (if there is any) in this leg of the trade and since you are now exercising on the ex-dividend date (not the day before) you would not be entitled to receive the dividend. Often it may be a smarter move to close out the back-month position by selling to close the long option on the open market, then buying the stock as soon as possible on the market. The move still captures the time premium of the back-month call while removing the short stock risk created by the assignment. If this does happen, quite frankly, it’s still not a good scenario for the trader. If the dividend is large enough this is a scenario where you could lose more than you initially paid for the long calendar spread.

This “damage-control” strategy for short call calendars and vertical spreads is pretty similar to what’s outlined above: don’t panic. You’re able to anticipate dividends as a driver for potential assignment, and try to close out the whole position if you think an early assignment is possible.

Think of assignment risk to calendar spreads like playing on the city streets: It’s better to get out of the way when you first see the car, than it is to hope the driver sees you and decides to stop or swerve.

Translation into options-terms: if you do decide to take the gamble, keep an eagle-eye on when that dividend is paying out. If the short front-month is in-the-money and expiration is approaching, beware: it’s usually better to close the whole spread before an assignment can mess it up than it is to hope you’re not assigned and then have to react after the fact. Depending on your risk tolerance, it may be best not to play in the street at all - avoid putting calendars on for large dividend-paying stocks, especially if the ex-dividend date is near the expiration date of the front-month call option.

As I mentioned before, put assignment risk is driven by different factors than those affecting calls. If there’s a dividend being paid out on a put, that’ll actually work as a deterrent to assignment, because put owners usually don’t want to exercise before the ex-date and be short the stock, requiring them to pay out the dividend. That said, whenever a put starts to get deep in-the-money and the options value is becoming more and more intrinsic value with very little time value, the risk of early assignment will be there. If it happens, don’t panic, as you can always exercise the long back-month option. You might alternatively be able to eke out a few nickels or dimes by selling the long put option and at the same time selling the stock that was put to you on the open market.
More...

OddTrader · Sep 17, 2016

http://www.optiontradingpedia.com/answers/what_to_do_when_one_leg_of_bull_call_spread_assigned.htm

In conclusion, when the short call options in your bull call spread is assigned, all you have to do is to close the position by closing out both legs as individual trades. Be sure to leg out of the position correctly to ensure preservation of profits.
More...

http://www.optiontradingpedia.com/answers/what_happens_if_short_leg_of_bull_call_spread_assigned.htm

In conclusion, it is not likely for out of the money short call options to be assigned early and for a bull call spread, you really should be closing the position before the short call options go too much in the money. If the short call options are assigned early and you do not have the cash margin to hold the resultant short stock position, your broker would most likely liquidate those short stocks for you the moment the assignment is complete.
More...

OddTrader · Sep 17, 2016

https://www.elitetrader.com/et/threads/early-assignment-on-the-short-leg-of-a-spread.176508/

AlmostGotIt said:
If youâre in a vertical spread, and the short option gets assigned early --- and you donât have enough capital in the account to cover the margin on being short the stock --- will the long option be auto exercised early to cover it? Or basically, how bad could I be screwed by a situation like this?
More...

AlmostGotIt said:
That's very good advice Mark, I had a support request pending with my broker in parallel with this question, time was getting tight... turns out my assumption was correct, with a vertical spread, I can just exercise the long call in the event the short call is assigned early, it will negate the short, and I retain the pnl from the spread.
More...

JackRab · Sep 19, 2016

Being assigned early is a good thing...

There are only a few true reasons for exercising early:

- exercise of ITM calls due to upcoming dividend
- exercise of ITM puts due to high interest rate cost of holding stock in combo with ITM puts
- exercise of ITM calls due to extremes in short stock lending...

Any other situation, if you're assigned early you will gain due to early capture of the interest component or better yet the premium above intrisic value.

In the 3 mentioned situations, the call or put will have a delta of 1, so swap for the stock shouldn't make a big difference... unless you can't make the payment or deliver.

I personally would love to be called early... money in the bag

OddTrader · Sep 19, 2016

JackRab said:
Being assigned early is a good thing...

There are only a few true reasons for exercising early:

- exercise of ITM calls due to upcoming dividend
- exercise of ITM puts due to high interest rate cost of holding stock in combo with ITM puts
- exercise of ITM calls due to extremes in short stock lending...

Any other situation, if you're assigned early you will gain due to early capture of the interest component or better yet the premium above intrisic value.

In the 3 mentioned situations, the call or put will have a delta of 1, so swap for the stock shouldn't make a big difference... unless you can't make the payment or deliver.

I personally would love to be called early... money in the bag
More...

ITM?

http://www.cboe.com/LearnCenter/OnlineU/Modules/Module30-00/VerticalSpreads.pdf

Assignment Risk
Assignment on any Equity option or American-style index option can, by contract terms, occur at anytime before expiration, although this generally occurs when the option is in-the-money.

Equity Options
For an equity put option, early assignment generally occurs when the short put is deep in-the-money, expiration is relatively near, and its premium has little or no time value. If a bear put spread holder is assigned early on the short put, then he may exercise his long put and sell shares purchased per the assignment obligation. In this case, maximum profit on the bear put spread would be realized.

American-Style Index Options
If early assignment is received on the short put of a bear put spread, the cash settlement procedure for index options will create a debit in the investor’s brokerage account equal to the cash settlement amount. This cash amount is determined at the end of the day the long put is exercised by its owner. After receiving assignment notification, usually the next business day, when the investor exercises his long put the cash settlement amount credited to his account will be determined at the end of that day. There is a full day’s market risk if the long option is not sold during the trading day assignment is received.
More...

What is Early Exercise and Assignment?

http://www.optionsplaybook.com/managing-positions/early-options-exercise/

Sometimes You Need to Exercise Early!

Early exercise happens when the owner of a call or put invokes his or her contractual rights before expiration. As a result, an option seller will be assigned, shares of stock will change hands, and the result is not always pretty for the seller. (It’s important to note that when talking about early exercise and assignment, we’re referring only to “American-style” stock options.)

Being required to buy or sell shares of stock before you originally expected to do so can impact the potential risk or reward of your overall position and become a major headache. But chances are, if you sell options — either as a simple position or as part of a more complex strategy — sooner or later, you’ll get hit with a surprise early assignment. Many traders fail to plan for this possibility and feel like their strategy is falling apart when it does happen.

The strategies that can be messed up the most by early assignment tend to be multi-leg strategies like short spreads, butterflies, long calendar spreads and diagonal spreads. The latter two strategies can go particularly haywire as a result of early assignment, because you’re dealing with multiple expiration dates.

In most cases, it’s a bad idea for option owners to exercise early. However, there are a few instances when exercising early does make sense.

As an option seller, you’re at risk of early assignment at any time. And it’s impossible to predict whether an option owner will exercise early for the right reasons or the wrong reasons. But understanding the pros and cons of early exercise can make you more aware of when you might be at risk of early assignment.

The likelihood of a short option being assigned early depends on whether the option you sold is a call or a put. So let’s examine each separately.

Three Reasons Not to Exercise Calls Early

Keep your risk limited

If you own a call, your risk is limited to the amount you paid for the option, even if the stock drops to zero. But if you own 100 shares of the stock and it completely tanks, you’ll be left holding the bag.

If your call is in-the-money prior to expiration, it makes little sense to exercise early. That’s because you can be party to gains without assuming the bigger downside that comes with owning the stock. If you do exercise your in-the-money call early and buy the stock, but then the stock falls below your strike price before expiration, you’ll really have egg on your face. In this case, you could have let the option expire worthless and bought the stock at a lower price on the open market.

Save your cash

If you exercise a call early and buy the stock, you’ll spend cash sooner instead of later. You already know how much you are going to pay for the stock, namely, the call’s strike price. So why not keep your cash in an interest-bearing account for as long as possible before you pay for those shares? Disciplined investors look for every opportunity to achieve maximum return on their assets, and this one happens to be a complete no-brainer.

Don't miss out on time value

By exercising a call early, you may be leaving money on the table in the form of time value left in the option’s price. If there is any time value, the call will be trading for more than the amount it is in-the-money. So if you want to own the stock immediately, you could simply sell the call and then apply the proceeds to the purchase of the shares. Factoring in the extra time value, the overall cost you’ll pay for the stock will be less than if you had exercised your call outright.

One circumstance when it might make sense to exercise a call early: approaching dividends

The exception to these three rules occurs when a dividend is going to be paid on the stock. Call buyers are not entitled to dividend payments, so if you want to receive the dividend, you have to exercise the in-the-money call and become a stock owner.

If the upcoming dividend amount is larger than the time value remaining in the call’s price, it might make sense to exercise the option. But you have to do so prior to the ex-dividend date.

So always be aware of dividends whenever you’ve sold a call contract — especially when the ex-dividend date occurs close to expiration, the call is in-the-money, and the dividend is relatively large.
Puts are at greater risk of early assignment as time value becomes negligible

In the case of puts, the game changes. When you exercise a put, you’re selling stock and receiving cash. So it can be tempting to get cash now as opposed to getting cash later. However, once again you must factor time value into the equation.

If you own a put and you want to sell the stock before expiration, it’s usually a good idea to sell the put first and then immediately sell the stock. That way, you’ll capture the time value for the put along with the value of the stock.

However, as expiration approaches and time value becomes negligible, it’s less of a deterrent against early exercise. That’s because by exercising you can accomplish your aim all in one simple transaction without any further hassles.

If you’ve sold a put, remember that the less time value there is in the price of the option as expiration approaches, the more you will be at risk of early assignment. So keep a close eye on the time value left in your short puts and have a plan in place in case you’re assigned early.

Dividends as a deterrent against early put exercise

As opposed to calls, an approaching ex-dividend date can be a deterrent against early exercise for puts. By exercising the put, the owner will receive cash now. However, this will create a short sale of stock if the put owner wasn’t long that stock to begin with. So exercising a put option the day before an ex-dividend date means the put owner will have to pay the dividend.

So if you’ve sold a put, this means you may have a lower chance of being assigned early, but only until the ex-dividend date has passed.

What to do if you're assigned early on a short option in a multi-leg strategy

Early assignment on a short option in a multi-leg strategy can really pull a leg out from under your play. If this happens, there’s no hard-and-fast rule on what to do. Sometimes you’ll want to exercise any long options and sometimes you’ll just want to close your entire position. But it’s always a good idea to keep a swear jar and some small bills near your computer just in case.

If you are assigned early on a multi-leg strategy, feel free to give us a call at TradeKing and we’ll help you handle it in the most opportune way.

American-style vs. European-style options

When it comes to exercise and assignment, there are two “styles” of options: European-style and American-style. But don’t let the names throw you. They have nothing to do with where the options are traded. In fact, both American- and European-style options are traded on U.S. exchanges. The different styles simply refer to when the options may be exercised and assigned.

American-style Options are Great. Just Like Sliced BreadAmerican-style options can be exercised by the owner at any time before expiration. Thus, the seller of an American-style option may be assigned at any time before expiration.

As of this writing, all equity options are American-style contracts. And generally speaking, options based on exchange-traded funds (ETFs) are also American-style contracts.

European-style Options are Great Too. In a Baguette Kind of WayEuropean-style options can be exercised only at expiration, so the seller doesn’t have to worry about being assigned until then. Most index options are European-style.

Before you set up a position, it’s critical to know whether the options you’re trading are American- or European-style, so you’ll know if early exercise or assignment is a possibility for you.

Just keep in mind that either style of option can still be bought or sold to close your position in the marketplace at any point during the contract’s lifetime.
More...

donnap · Sep 19, 2016

JackRab said:
Being assigned early is a good thing...

There are only a few true reasons for exercising early:

- exercise of ITM calls due to upcoming dividend
- exercise of ITM puts due to high interest rate cost of holding stock in combo with ITM puts
- exercise of ITM calls due to extremes in short stock lending...

Any other situation, if you're assigned early you will gain due to early capture of the interest component or better yet the premium above intrisic value.

In the 3 mentioned situations, the call or put will have a delta of 1, so swap for the stock shouldn't make a big difference... unless you can't make the payment or deliver.

I personally would love to be called early... money in the bag
More...

Good post, but disagree on a few points.

Yeah, generally, early assignment is great, assuming that the assignee has the capital to cover the UL. I almost always trade this way, although early assignments have been rare.

Generally, if the option has a delta of 1, early assignment becomes very possible, regardless of the reason for delta = 1. Sometimes, it is not easy to determine the exact true value of delta.

In the case of American style ITM calls and upcoming div. it is possible to lose on assignment because the Euro value of the call is below parity. That's why these options are exercised, because pre div. parity is a greater value than post-div. value.

OddTrader · Sep 19, 2016

donnap said:
Good post, but disagree on a few points.

Yeah, generally, early assignment is great, assuming that the assignee has the capital to cover the UL. I almost always trade this way. Although early assignments have been rare.

Generally, if the option has a delta of 1, early assignment becomes very possible, regardless of the reason for delta = 1. Sometimes, it is not easy to determine the exact true value of delta.

In the case of American style ITM calls and upcoming div. it is possible to lose on assignment because the Euro value of the call is below parity. That's why these options are exercised, because pre div. parity is a greater value than post-div. value.
More...

How about:

1. Early assignment Only for American options!?

2. Any short options could be early assigned, regardless of delta value!?

donnap · Sep 19, 2016

True, the terms of the contract are the key. It's all about the probability of early assignment.

If the option can be sold for more than parity, then the market value is greater than the exercise value, so, generally, those options will not be exercised early.

Some years ago I experienced a strange case of assignment where the options had considerable time value left, but I think that that is rare and happened more often in the early days of option trading.

Unshortable or HTB stocks are another case where early call assignment is undesirable. If you are bought in by your broker, then the position becomes out of balance. One assumes that one can hold the stock, but that is not always the case.