Your preferred way of handling early assignments?

Discussion in 'Options' started by OddTrader, Sep 17, 2010.

  1. I'm very new and inexperienced in writing (futures) options. Feeling not exactly sure how the dynamics and complexity work. Also worried about the risks of how to determine whether I'm in danger of being assigned.

    1. What have been your personal experences about advantages and disadvantages of early assignments (particularly futures options)?

    2. Definitely I don't want to hold a written options position too close to the expiration week. However, how much depth (in terms of delta) being ITM I should take some kinds of adjustment action for an ITM options? Or I should simply wait and see until getting assigned.

    3. How about if I’m early assigned but without knowing it for a few days (due to travelling overseas). What happens to me?

    4. Do you have any preferred way(s) of handling early assignments of options?
     
  2. Perhaps applying the following principles would be useful:

    http://en.wikipedia.org/wiki/Risk_management

    "Risk Options

    Risk mitigation measures are usually formulated according to one or more of the following major risk options, which are:

    1. Design a new business process with adequate built-in risk control and containment measures from the start.

    2. Periodically re-assess risks that are accepted in ongoing processes as a normal feature of business operations and modify mitigation measures.

    3. Transfer risks to an external agency (e.g. an insurance company)

    4. Avoid risks altogether (e.g. by closing down a particular high-risk business area)

    Later research[citation needed] has shown that the financial benefits of risk management are less dependent on the formula used but are more dependent on the frequency and how risk assessment is performed.

    In business it is imperative to be able to present the findings of risk assessments in financial terms. Robert Courtney Jr. (IBM, 1970) proposed a formula for presenting risks in financial terms.[8] The Courtney formula was accepted as the official risk analysis method for the US governmental agencies. The formula proposes calculation of ALE (annualised loss expectancy) and compares the expected loss value to the security control implementation costs (cost-benefit analysis).

    Potential risk treatments

    Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories:[9]

    * Avoidance (eliminate, withdraw from or not become involved)
    * Reduction (optimise - mitigate)
    * Sharing (transfer - outsource or insure)
    * Retention (accept and budget)

    Ideal use of these strategies may not be possible. Some of them may involve trade-offs that are not acceptable to the organization or person making the risk management decisions. Another source, from the US Department of Defense, Defense Acquisition University, calls these categories ACAT, for Avoid, Control, Accept, or Transfer. This use of the ACAT acronym is reminiscent of another ACAT (for Acquisition Category) used in US Defense industry procurements, in which Risk Management figures prominently in decision making and planning.

    Risk avoidance

    This includes not performing an activity that could carry risk. An example would be not buying a property or business in order to not take on the legal liability that comes with it. Another would be not be flying in order to not take the risk that the airplane were to be hijacked. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning profits.
    [edit] Hazard Prevention
    Main article: Hazard prevention

    Hazard prevention refers to the prevention of risks in an emergency. The first and most effective stage of hazard prevention is the elimination of hazards. If this takes too long, is too costly, or is otherwise impractical, the second stage is mitigation.

    Risk reduction

    Risk reduction or "optimisation" involves reducing the severity of the loss or the likelihood of the loss from occurring. For example, sprinklers are designed to put out a fire to reduce the risk of loss by fire. This method may cause a greater loss by water damage and therefore may not be suitable. Halon fire suppression systems may mitigate that risk, but the cost may be prohibitive as a strategy.

    Acknowledging that risks can be positive or negative, optimising risks means finding a balance between negative risk and the benefit of the operation or activity; and between risk reduction and effort applied. By an offshore drilling contractor effectively applying HSE Management in its organisation, it can optimise risk to achieve levels of residual risk that are tolerable.[10]

    Modern software development methodologies reduce risk by developing and delivering software incrementally. Early methodologies suffered from the fact that they only delivered software in the final phase of development; any problems encountered in earlier phases meant costly rework and often jeopardized the whole project. By developing in iterations, software projects can limit effort wasted to a single iteration.

    Outsourcing could be an example of risk reduction if the outsourcer can demonstrate higher capability at managing or reducing risks.[11] For example, a company may outsource only its software development, the manufacturing of hard goods, or customer support needs to another company, while handling the business management itself. This way, the company can concentrate more on business development without having to worry as much about the manufacturing process, managing the development team, or finding a physical location for a call center.

    Risk sharing

    Briefly defined as "sharing with another party the burden of loss or the benefit of gain, from a risk, and the measures to reduce a risk."

    The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that you can transfer a risk to a third party through insurance or outsourcing. In practice if the insurance company or contractor go bankrupt or end up in court, the original risk is likely to still revert to the first party. As such in the terminology of practitioners and scholars alike, the purchase of an insurance contract is often described as a "transfer of risk." However, technically speaking, the buyer of the contract generally retains legal responsibility for the losses "transferred", meaning that insurance may be described more accurately as a post-event compensatory mechanism. For example, a personal injuries insurance policy does not transfer the risk of a car accident to the insurance company. The risk still lies with the policy holder namely the person who has been in the accident. The insurance policy simply provides that if an accident (the event) occurs involving the policy holder then some compensation may be payable to the policy holder that is commensurate to the suffering/damage.

    Some ways of managing risk fall into multiple categories. Risk retention pools are technically retaining the risk for the group, but spreading it over the whole group involves transfer among individual members of the group. This is different from traditional insurance, in that no premium is exchanged between members of the group up front, but instead losses are assessed to all members of the group.

    Risk retention

    Involves accepting the loss, or benefit of gain, from a risk when it occurs. True self insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible. War is an example since most property and risks are not insured against war, so the loss attributed by war is retained by the insured. Also any amounts of potential loss (risk) over the amount insured is retained risk. This may also be acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals of the organization too much. "
     
  3. In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality at a specified future date at a price agreed today (the futures price). The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They are still securities, however, though they are a type of derivative contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.

    The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract.

    In many cases, the underlying asset to a futures contract may not be traditional "commodities" at all – that is, for financial futures, the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates.

    The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange[1].

    A closely related contract is a forward contract; they differ in certain respects. Future contracts are very similar to forward contracts, except they are exchange-traded and defined on standardized assets.[2] Unlike forwards, futures typically have interim partial settlements or "true-ups" in margin requirements. For typical forwards, the net gain or loss accrued over the life of the contract is realized on the delivery date.

    A futures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereas an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the option. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations.

    Futures contracts, or simply futures, (but not future or future contract) are exchange-traded derivatives. The exchange's clearing house acts as counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement

    Aristotle described the story of Thales, a poor philosopher from Miletus who developed a "financial device, which involves a principle of universal application". Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or poor and because the olive press owners were willing to hedge against the possibility of a poor yield. When the harvest time came, and many presses were wanted concurrently and suddenly, he let them out at any rate he pleased, and made a large quantity of money.[4]

    The first futures exchange market was the Dôjima Rice Exchange in Japan in the 1730s, to meet the needs of samurai who – being paid in rice, and after a series of bad harvests – needed a stable conversion to coin.[5]

    The Chicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded' forward contracts in 1864, which were called futures contracts. This contract was based on grain trading and started a trend that saw contracts created on a number of different commodities as well as a number of futures exchanges set up in countries around the world.[6] By 1875 cotton futures were being traded in Mumbai in India and within a few years this had expanded to futures on edible oilseeds complex, raw jute and jute goods and bullion.

    Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

    The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.

    The type of settlement, either cash settlement or physical settlement.

    The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.

    The currency in which the futures contract is quoted.

    The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity, as well as the pricing point -- the location where delivery must be made.

    The delivery month.

    The last trading date.

    Other details such as the commodity tick, the minimum permissible price fluctuation
     
  4. To minimize credit risk to the exchange, traders must post a margin or a performance bond, typically 5%-15% of the contract's value.

    To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty.

    Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.

    Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers.

    Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin.

    Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange.

    If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned.

    In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as “variation margin”, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day.

    Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the client’s account.

    Some U.S. exchanges also use the term “maintenance margin”, which in effect defines by how much the value of the initial margin can reduce before a margin call is made. However, most non-US brokers only use the term “initial margin” and “variation margin”.

    The Initial Margin requirement is established by the Futures exchange, in contrast to other securities Initial Margin (which is set by the Federal Reserve in the U.S. Markets).

    A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.

    Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account.

    Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn't want to be subject to margin calls.

    Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.

    Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.

    [edit] Settlement - physical versus cash-settled futures
    Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:

    Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method of settlement upon expiration

    Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires.[8] Cash settled futures are those that, as a practical matter, could not be settled by delivery of the referenced item - i.e. how would one deliver an index? A futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures use this method.
    Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a futures contract stops trading, as well as the final settlement price for that contract. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading months. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiration of the December contract, the March futures become the nearest contract. This is an exciting time for arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes) during which the underlying cash price and the futures price sometimes struggle to converge. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour.
     
  5. Here is one of the Many possible strategies:

    http://en.wikipedia.org/wiki/Exercise_(options)

    "
    Early Exercise Strategy

    A common strategy among professional option traders is to sell large quantities of in-the-money calls just prior to an ex-dividend date. Quite often, non-professional option traders may not understand the benefit of exercising a call option early, and therefore may unintentionally forego the value of the dividend. The professional trader may only be 'assigned' on a portion of the calls, and therefore profits by receiving a dividend on the stock used to hedge the calls that are not exercised.

    "
     
  6. Here is another quote from a web site:

    "

    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

    "
     
  7. 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 EarlyKeep 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.
     
  8. One circumstance when it might make sense to exercise a call early: approaching dividendsThe 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 negligibleIn 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 exerciseAs 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 strategyEarly 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 optionsWhen 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 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 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.
     
    #10     Sep 25, 2010