Can Options Assignment Cause Margin Call?
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By Mark Wolfinger
Looking at a common situation, suppose that you have written a covered call. You owned 300 shares of YFS (Your Favorite Stock Inc.), watched it rally, and finally decided that it’s time to sell the shares because you believe they are fully priced at $41 per share.
Instead of selling the shares outright, you decided to milk this trade for additional profits and wrote three YFS March 40 Calls, collecting a premium of $2.50. If the stock is above $40 when expiration arrives, you will sell the shares at $40. Adding the option premium, your net is $42.50 instead of $41. Sure, there’s some downside risk prior to expiration, but you decide to accept that risk.
All goes well, the stock rallies further and when it’s trading at $44, you are surprised to be assigned an exercise notice because it’s one week before expiration. There was no reason for the option owner to exercise and the stock did not go ex-dividend. Nevertheless, you sold your stock, earned your profit and even collected the cash one week early. This is all good.
In most cases that’s the end of the story. However, on this occasion you learn the importance of not exercising an option earlier than necessary. On Monday and Tuesday of expiration week, overseas markets tumbled and the U.S. market followed suit. On top of that, YFS issues some minor news that, under ordinary market conditions, would have been shrugged off. However, with the nervous market and a substantial two-day decline, YFS fell out of bed. When the market opened Wednesday morning, it was trading south of $37 per share.
If you had not been assigned early, you would own stock and have no chance to sell at $40. So give a big “thank you” to the person who made the terrible decision to exercise.
Think of it this way — it’s exactly the same as if the person who exercised your calls said to you:
“Here is a FREE put option. I’m taking your stock now and in its place you now own three March 40 YFS put options. If the stock trades below $40 next week, you will have the right to sell those shares at $40. In reality you already sold the shares, but because most stockholders were not assigned an exercise notice, I’ve given you a special gift: three put options. I did this because I am certain these puts are worthless, but they are yours with my compliments.”
Of course, the exerciser does not truly think that way or else he/she would have never exercised early. This time you were saved from taking a loss. If YFS dips low enough that you want to repurchase the shares, you are in position to do so. If you still owned the original shares, you would not have the ready cash to make that choice.
Being assigned on a call option is the same as being handed a free put. Being assigned early on a put option is equivalent to being handed a free call. These “imaginary, free” options have the same strike and expiration date as the real options on which you were assigned.
Don’t be unhappy when assigned. It can be a rare gift.
Like this article? Visit our Options Education Center and Options Trading Blog for more.
Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
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By Pat Crawley
But in this article, we're going to show you why early assignment is a vastly overblown fear, why it's not the end of the world, and what to do if it does occur.
What is Assignment in Options Trading?
Do you remember reading beginner options books or articles that said, "an option gives the buyer the right, but not the obligation, to buy/sell a stock at a specified price and date?" Well, it's accurate, but only for the buy side of the contract.
The seller of an option is actually obligated to buy or sell should the buyer choose to exercise their contract. So when options, assignment is when you, the lucky seller of an options contract, get chosen to make good on your obligation to buy or sell the underlying asset.
Let's say you sold a call option on a stock with a strike price of $50, which you held until expiration. At expiration, the stock trades at $55, meaning it's automatically exercised by the buyer. In this case, you are forced to sell the buyer 100 shares at $50 per share.
So when selling options, assignment is when you, the lucky seller of an options contract, get chosen to make good on your obligation to buy or sell the underlying asset.
What is Early Assignment in Options Trading?
Early assignment is when the buyer of an options contract that you're short decides to exercise the option before the expiration and begins the assignment process.
Many beginning traders count early assignments as one of their biggest trading fears. Many traders' fear of early assignment stems from their lack of understanding of the process. Still, it's typically not something to worry about, and we'll show you why in this article. But first, let's look at an example of how the process works.
For instance, say we collect $1 in premium to short a 30-day put option on XYZ with a strike price of $45 while the underlying is trading at $50. Fast forward, and it's the morning of expiration day. Options will expire at the close of trading in a few hours. The underlying stock is hovering around $44.85. Our plan pretty much worked as planned until, for some reason, the holder of the option exercises the option. We're confused and don't know what's going on.
It works exactly the same way as ordinary options settlement. You fulfill your end of the bargain. As the seller of a put option, you sold the right to sell XYZ at $45. The option buyer exercised that right and sold his shares to you at $45 per share.
And now, let's break down what happened in this transaction:
You collected $1 in premium when opening the contract
The buyer of the option exercises his right to sell at $45 per share.
You’re now long 100 shares of XYZ that you paid $45 for, and you sell them at the market price of $44.80 per share, realizing a $0.20 per share loss.
Your profit on the transaction is $0.80 because you pocketed $1 from the initial sale of the option but lost $0.20 from selling the 100 shares from assignment at a loss.
Why Early Assignment is Nothing to Fear
Many beginning traders count early assignments as one of their biggest trading fears; on some level, it makes sense. As the seller of an option, you're accepting the burden of a legitimate obligation to your counterparty in exchange for a premium. You're giving up control, and the early assignment shoe can, on paper, drop at any time.
Exercising Options Early Burns Money
People rarely exercise options early because it simply doesn't make financial sense. By exercising an option, you're only capturing the option's intrinsic value and entirely forfeiting the extrinsic value to the option seller. There's seldom a reason to do this.
Let's put ourselves in the buyer's shoes. For instance, we pay $5 for a 30-day call with a strike price of $100 while the underlying is trading at $102. The call has $2 in intrinsic value, meaning our call is in-the-money by $2, which would be our profit if the option expired today.
The other $3 of the option price is extrinsic value. This is the value of time, volatility, and convexity. By exercising early, the buyer of an option is burning that $3 of extrinsic value just to lock in the $2 profit.
A much better alternative would be to sell the option and go and buy 100 shares of the stock in the open market.
Viewed in this light, an option seller can’t be blamed for looking at early assignment as a good thing, as they get to lock in their premium as profit.
Your Risk Doesn’t Change
One of the biggest worries about early assignment is that being assigned will somehow open the trader up to additional risk. For instance, if you’re assigned on a short call position, you’ll end up holding a short position in the underlying stock.
However, let me prove that the maximum risk in your positions stays the same due to early assignment.
How Early Assignment Doesn’t Change Your Position’s Maximum Risk
Perhaps you collect $2.00 in premium for shorting an ABC $50/$55 bear call spread. In other words, we're short the $50 call for a credit of $2.50 and long the $55 call, paying a debit of $0.50.
Before considering early assignment, let's determine our maximum risk on this call spread. The maximum risk for a bear call spread is the difference between the strike minus the net credit you receive. In this case, the difference between the strikes is $5, and we collect a net credit of $2, making our maximum risk on the position $3 or $300.
You wake up one morning with the underlying trading at $58 to find that the counterparty of your short $50 call has exercised its option, giving them the right to buy the underlying stock at $50 per share.
You'd end up short due to being forced to sell the buyer shares at $50. So you're short 100 shares of ABC with a cost basis of $50 per share. On that position, your P&L is -$800, the P&L on a $55 long call is +$250, on account of you paying $0.50, and the call being $3.00 in-the-money. And finally, because the option holder exercised early, you get to keep the entire credit you collected to sell the $50 call, so you've collected +$250.
So your P&L is $300. You've reached your max loss. Let's get extreme here. Suppose the price of the underlying runs to $100. Here are the P&Ls for each leg of the trade:
Short stock: -$5,000
Long call: +$4,450
Net credit received from exercised short option: +$250
5,000 - (4,450 + 250) = $300
While dealing with early assignments might be a hassle, it doesn’t open a trader up to additional risk they didn’t sign up for.
Margin Calls Usually Aren’t The End of the World
Getting a margin call due to early assignment isn't the end of the world. Believe it or not, stock brokerages have been around for a long time. They have seen early assignments many times before, and they have protocols for it.
Think about it intuitively, your broker allowed you to open the short option position knowing that the capital in your account could not cover an early assignment. Still, they let you make the trade anyways.
So what happens when you get an early assignment that you can’t cover? Your broker issues you a margin call. Once you’re in violation of their margin rules, they pretty much have carte blanche to handle the situation as they wish, including liquidating the assigned stock position at their will.
However, most brokers will give you some time to react to the situation and either decide to deposit more capital, liquidate the position on your own, or exercise offsetting options to fulfill the margin call in the case of an option spread.
Even though a margin call isn't fun, remember that the overall risk of your position doesn't change due to an early assignment, and it's typically not a momentous event to deal with. You probably just have to liquidate the trade.
When Early Assignment Might Occur?
Dividend Capture
One of the few times it might make sense for a trader to exercise an option early is when he's holding a call that is deep in-the-money, and there's an upcoming ex-dividend date.
Because deep ITM calls have very little extrinsic value (because their deltas are so high), any negligible extrinsic value is often outweighed by the value of an upcoming dividend payment, so it makes sense to exercise and collect the dividend.
Deep In-The-Money Options Near Expiration
While it's important to emphasize that the risk of early assignment is very low in most cases, the likelihood does rise when you're dealing with options with very little extrinsic value, like deep-in-the-money options. Although, even in those cases, the probabilities are pretty low.
However, an options trader that is trading to exploit market anomalies like the volatility risk premium, in which implied volatility tends to be overpriced, shouldn't even be trading deep-in-the-money options anyhow. Profitable option sellers tend to sell options with very little intrinsic value and tons of extrinsic value.
Bottom Line
Don't let the fear of early assignment discourage you from selling options. Far worse things when shorting options! While it's true that early assignment can occur, it's typically not a big deal.
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By cwelsh
Option assignments occur in two basic varieties. First, on expiration Friday (or Thursday or Wednsday depending on the instrument your trading, but most commonly on Friday). If you have a position that is .01 in the money, or more, you WILL be assigned. For instance, if you have a 100 Call on stock XYZ that expires today, and XYZ closes (AFTER HOURS) at 100.01, you will find that you own, sometime Saturday, 100 shares of XYZ that you paid $100/share for.
Now this option might have only cost you $100 or so. But all of a sudden, due to the inherent multiplier in options, you are now out of pocket $10,000.00. What if you're account only had $5,000.00 in it? Well, you are going to get both (a) a Regulation T Notice and (b) margin call from your broker. First thing Monday morning, your broker will automatically liquidate the position. What if there is adverse news over the weekend and the opening price is only $80? Well you just lost $2,000.0 -- in a $5,000.00 account. In other words, that $100 option just cost you 40% of your entire account. This happens.
What if you had "hedged" the position though, and had a vertical call spread? For instance, you might have bought the $100/$105 spread on XYZ. Well if XYZ closes anywhere above $105 you are ok because BOTH positions will be auto-exercised. This SOMETIMES results in a margin call as well -- but don't worry. Option clear throughout the day on Saturday and your account will frequently show one position and the other not exercised yet. By Sunday morning it will be fixed. By way of example, I had a very large position (for me) (20 contracts) in the LNKD 92.5/95 vertical call before earnings. Well earnings did what they were supposed to and LNKD jumped to 104. Well Saturday morning, all of a sudden, I was SHORT 2000 shares of LNKD and had received roughly $190K in cash into my account. This sends off all kinds of margin alerts. I got an email, a call, and another call. Ignore them, they're idiots. The 92.5 side simply hadn't cleared yet. Three hours later the other option cleared, buying the shorts back at 92.5. Then Sunday morning, your account statement will reflect that all trades happened at the same time.
HOWEVER, what if, on that 100/105 spread, XYZ closes at 103 on Friday? Well, guess what, you'll be assigned on the 100 position, the 105 will expire worthless, and now your back in margin call.
MORAL OF THE STORY:
DON'T EVER LET YOURSELF BE ASSIGNED ON A SPREAD THAT'S NOT FAR IN THE MONEY ON BOTH LEGS.
What if, on Friday, the price of XYZ was at $106 at close? You better have closed the spread, because of after hours trading. The price of XYZ can move after hours -- but you can't get out of the options. So if the market closes at 106, and you say good, both legs will clear and I won't pay commissions (or pay less commissions) and get a huge tax break, you could be wrong, as in after hours the market might go back to $104.98. Then you're screwed, only the 100 option gets exercised and you go into margin call. I'm convinced when your near a strike the market makers manipulate the after hours markets to have this happen.
Of course if you have enough cash in your account, you won't get margin called -- you're risk profile will just be largely out of whack.
And this isn't to say you can't have a big benefit from this. My single most profitable trade EVER occurred on a spread that was $.50 above the line, I didn't close it, and then in after hours the price dropped. So I got assigned long on the lower strike. Well, that weekend there was big news involving the company and the price jumped 15% the next morning. In that case, here's what happens -- I own the 100 (long) /105 (short) vertical. After hours, the price is $104.92. Well that spread was worth $4.85 at close on 20 contracts, or $9,700. Well, Saturday I'm now the proud owner of 2,000 shares bought at $100.00 each, for a net cost of $200,000 -- oops. Margin call, broker call, broker email, etc. Well they inform me the trade will immediately close at open on Monday. Well the price jumped, and the position was closed, at $240,000.00. My original investment of $8,500.00, that I didn't want to close at $9,700.00, netted me $40,000.00, or roughly a 470% return. BUT, what if the price had gone down 20%? Well I would be owing my broker money and have completely blown out my account.
If you have ANY questions on this, please let me know.
Now SITUATION TWO -- and you will, sooner or later, encounter this. Let's say we have that same 100(long)/105 (short) spread on XYZ. Only we own the September spread and today (Friday) XYZ closes at 103. No bigger. UNLESS someone exercises their 100 spread. American style options can be exercised at anytime. Why would this happen with time value? Who knows, most likely someone needed to unwind a position, hedge something, take profits, any number of things really.
Well if you had a 10 contract position, on Saturday your account is now down $100,000.00 in cash and you won 1,000 shares of XYZ. You will again go into margin call. However, while this is a headache and you will have to deal with your broker, you don't need to panic because the position is still hedged. You can certainly still lose money -- but only up to the 105 line.
What happens? Well your broker will force you to exit the position Monday morning at the open. If you BEG and wheedle, the broker might let you close the position yourself, so you can close at the midpoint instead of just a market order. They should let you do this because the position is still hedged, but you are technically in a Reg T violation, so they won't let you hold it for long. Monday you'll have to sell your shares and buy back the short calls. This should be, at worst, a break even situation because of the time value left in the short calls. However, markets fluctuate and you might have to sell your stock at something like 104 and by the time you exit the short calls its up to 105 (or you get a bad fill price) so you give back some.
When this happens, take your lumps and move on. I have this happen about once a quarter and my worse loss was 4%. There's nothing you can do to protect against this. You are hedged, and you won't blow your account out, but it does suck.
I hope that clears some things. If not, please let us know.
By Christopher B. Welsh
Christopher B. Welsh is a SteadyOptions contributor. He is a licensed investment advisor in the State of Texas and is the president of a small investment firm, Lorintine Capital, LP which is a general partner of two separate private funds. He offers investment advice to his clients, both in the law practice and outside of it. Chris is an active litigator and assists his clients with all aspects of their business, from start-up through closing.
Chris is managing the Anchor Trades portfolio.
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By cwelsh
It is not. (Well, it is rarely a problem). In fact, almost 99% of the time, early assignment is a better outcome. Below will set forth two common assignment examples, work through the potential outcomes, and demonstrate why assignment is typically a better outcome than having just held the position.
For Steady Option’s Anchor members, there is a persistent risk of being assigned a long stock position on the income producing portion of the strategy (the short SPY puts). This only happens in sharp market declines or very close to rolling of the position, but it can happen. Assignment risks increases the closer the position gets to a delta of 1. Most recently, this happened the week of May 13, 2019.For purposes of this example, we’ll use the actual SPY positions and walk through what did occur and could have occurred in other possible market situation.
In early May, the strategy sold four contracts of the May 20, 293 put for $3.11. The market started to drop. On May 19, 2019, the options were early exercised when SPY hit 285. The value of the contract when assigned was $8.11. All of a sudden, most accounts had 400 shares of SPY and were down $117,200 (4 contracts x 100 x $293). Most accounts don’t have cash in them to cover the position and may have received a Reg-T notice (a Reg-T notice is a form of a margin call by your broker). What is a trader to do?
Well first, the next trading day, simply close the position. Sell the stock, and the margin call should be covered. If it’s not, you can always sell other holdings to cover it. The way the Anchor Strategy is structured, it is virtually impossible not to have available cash or stock to cover in this situation. After closing the assigned position, is the trader worse or better off than if the position had been held? In all market conditions (up, down, flat), the trader is either in the same position as not having been assigned or better off.
Note: This assumption ignores transaction costs. Some accounts have assignment fees, different commissions for buying and selling stocks and options and other various fees. These fees could make a difference on the analysis, depending on a trader’s individual account. Since such fees vary widely, the below discussion ignores all fees.
The Market stays flat, SPY stays right at 285
In this case, the trader sells the assigned shares back at $285, facing a loss of $8.00/share. ($293 - $285)[1]. In other words, the trader has lost $1,956 ($8 stock loss less $3.11 received for selling the original position). This seems like a poor outcome.
[1] For purposes of this article, I am going to ignore the fact that the position was hedged and look at it just from the assignment point of view.
However, this is better than if the trader had just closed the short put at $8.11 at the market open. In that case, the trader would have lost $2,000. (($8.11 - $3.11) x 4 x 100). By being early assigned, the trader saved $0.11/share. This is what actually happened in actual trading the week of May 13.
The Market moves up the next morning
What would have happened though if the market had gone up? Let’s say to SPY $288. In this case, instead of selling the stock back at $285, you would sell it back at $288. That is a loss of $5 per share ($293 - $288) for a total loss of $756 on the trade ($5 - $3.11).
Once again, the trader is better off. Delta of the short put is not one, rather it had a dynamic average of .95. This means the value of the put would have declined not to $5.11 (the previous price of $8.11 - $5.11), but, by $2.85 to $5.26. Closing that option position would result in a loss of $860 on the trade ($5.26-$3.11).
The Market goes down
The scariest situation for a trader is waking up the next morning and the market has declined. Instead of SPY $285, the market might have continued to go down to SPY $282 (or worse). In this case, the trader sells the stock for $282, resulting in a loss of $11 per share for a total loss on the trade of $3,156 ($11-$3.11).
Yet again, the trader is better off. With the market going down from $285 to $282, the dynamic delta average is .98 and time value has dropped a bit, and the short put is now worth $11.03. Closing this put for a loss of $11.03 results in a total loss on the trade of $3,168. Even if the market had plunged down to SPY 100, the two positions would have been equivalent – meaning that the loss by being assigned equals the loss of having been in the short put.
In other words, in every market situation, the trader is either better off or exactly the same when assigned the position rather than having simply held the short put. The closer delta is to 1, the more likely you are to be assigned, but even in that situation, you would be no worse off between assignment and holding.
But if that’s true for puts, is it also true for calls?
Let’s take a common example. You sell 5 contracts of the $100 call on Stock ABC that is currently trading at $99 for $2.00. You are now short the $100 call. You receive $1,000. It expires in 3 weeks. Two weeks from now the stock is trading at $99.80 with earnings coming up tomorrow, and the option is trading at $1.00.You have $1,000 in cash and -$500 in call value. Someone exercises the option. The next morning your account looks like:
Short 500 shares ABC at a value of $49,900 Long $51,000 cash ($50,000 for sale of stock at $100/share plus $1,000 from the sale)
Are you in trouble? Did you lose money? Once again no, you’re not. Let’s look at what happens in each situation at market open:
The Market stays flat at $99.80
In this situation, you buy back the 500 shares of Stock ABC for $49,900. You keep the $51,000 and did not have to buy back the call. So you’re up $1,1000.
If you had not closed the position out, not been assigned, and the market stayed flat, the price of the option may have declined to around $0.50.
Clearly, you are better off because of the assignment – by over $800.
The Market goes down (any amount)
Earnings come out and the price drops to $90 (or any value below $100). In this situation, you buy back the 500 shares for $45,000. You keep the $51,000 and did not have to buy back the call. So you’re up $6,000.
If you had not closed the position out, not been assigned, and the market went down, the price of the option may have declined to $0.01.
Again, you are better off because of the assignment – by almost $6,000.
The Market goes up by less than $2 (to under $102)
Earnings come out, and the price increases to $102 (or anything between the last close and $102). You buy back the shares for $51,000. This nets out the cash you already had and did not have to buy back the calls. In this situation you break even.
If you had not closed the position out, not been assigned, and the market went up, the price of the option contract would have increased to at least $2.00.
In this case, you are in the same boat because of the assignment. Closing the short contract at $2.00 would cost you $1,000, which nets to $0.00 with the $1,000 you received from the sale.
The Market goes up by more than $2 (e.g. $110)
Earnings come out, and the price increases to $110. In this situation you must buy the shares back for $55,000. Offsetting with the cash already received, you have lost $4,000.
If you had not closed the position out, not been assigned, and the market went up a significant amount, the option price would have increased to at least $10. Closing this short contract out will cost $5,000. You are again better off because of the assignment.
In other words, in every situation you are in an equal or better situation because of an assignment. This is because options have time value – which an early assignment forfeits to the option contract holder. Even if the option contract had no time value left in it, the worst situation is still break even.
The only real risk to assignment is failing to quickly move and adjust the position (eliminate the oversized short position), your account goes into a Reg-T call, and your broker starts closing positions in a non-efficient manner.There are brokers who also require margin calls to be covered by cash deposits, instead of adjusting positions. (Very few). If that’s the case, you may get a demand for cash (and switch brokers).
As long as you stay on top of your positions and address any assignments, there is no reason to fear early assignment since in all situations you will be either equal or better off on early assignments. This is why I am almost always surprised by early assignments. The only time early assignment really ever makes sense is on surprise dividend announcements that weren’t originally calculated into the option prices – and even then, as the price of the option likely moved before the assignment occurred, there may be no impact.
What any option investor should always keep in mind is what to do if they get assigned early, what that will look like, and what trades will need to be entered the next business day. Being prepared prevents fear and mistakes – particularly when there is no need for that fear in the first place.
Christopher Welsh is a licensed investment advisor and president of LorintineCapital, LP. He provides investment advice to clients all over the United States and around the world. Christopher has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Christopher has a J.D. from the SMU Dedman School of Law, a Bachelor of Science in Computer Science, and a Bachelor of Science in Economics. Christopher is a regular contributor to the Steady Options Anchor Strategy and Lorintine CapitalBlog.
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By tjlocke99
Hello.
Recently I was researching what happens if I hold a covered call through earnings.
I came across this article on theoptionsguide.com
http://www.theoption...ered-calls.aspx
It discusses writing a covered call but shorting a DITM call to try to scalp the dividend.
It seems the reasons this strategy will not work is because it is likely you will be assigned on that DITM call.
However could someone explain to me how that would work? Let's take a hypothetical example:
GD ex-dividend date 10/3 for $.51 a share
Let's say GD is trading at $65.00
On 10/2 during the day you go long 100 shares and sell a $63 Oct call for $2.00 even.
On 10/3 the stock drops and closes at $64.50
What would happen regarding you being assigned? Also do you need to be long the shares on 10/2 or is getting long the shares on 10/3 sufficient to receive the dividend when it is payed?
Thank you!
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By Azov
Just wondering if anyone has ever had success negotiating with TOS to reduce/remove the $19.95 fee that TOS charges for assignment and exercise. If so, what kind of arguments worked best?
I agree with Kim that we shouldn’t have to negotiate to get the best rates. However, I greatly prefer TOS’s platform to anything else out there. I’ve been using tastyworks for a while now too, and their platform is only ok, but it’s still a work in progress, and they still charge $5 for assignment/exercise.
The reason I’m asking - and not considering IB’s $0 assignments- is because I’m evaluating a couple of candidates for wheel trades (sell puts, get assigned, sell covered calls, get assigned, rinse/repeat). Since the cycle involves two assignments, the $40-ish total fees at TOS is cost prohibitive. And I refuse to use IB because of their auto-liquidation algorithm - I don’t want to have my account blown up if I get assigned on a couple of different positions one night and don’t have a chance to close things out within 10 minutes of the market opening.
So if I could get TOS to come down or eliminate their assignment fee, that would be great. Otherwise I’m stuck with TW - I suppose I’ll get more used to their platform over time, but everything about their apps makes me feel like I’m playing an arcade game from the 80s. And not in a good way....
Any input is greatly appreciated!
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By cwelsh
If you don't you can find your entire account blown out over a weekend.
Assignments occur in two basic varieties. First, on expiration Friday (or Thursday or Wednesday depending on the instrument your trading, but most commonly on Friday). If you have a position that is .01 in the money, or more, you WILL be assigned. For instance, if you have a 100 Call on stock XYZ that expires today, and XYZ closes (AFTER HOURS) at 100.01, you will find that you own, sometime Saturday, 100 shares of XYZ that you paid $100/share for.
Now this option might have only cost you $100 or so. But all of a sudden, due to the inherent multiplier in options, you are now out of pocket $10,000.00. What if you're account only had $5,000.00 in it? Well, you are going to get both a Regulation T Notice and margin call from your broker. First thing Monday morning, your broker will automatically liquidate the position. What if there is adverse news over the weekend and the opening price is only $80? Well you just lost $2,000.0 -- in a $5,000.00 account. In other words, that $100 option just cost you 40% of your entire account. This happens.
What if you had "hedged" the position though, and had a vertical call spread? For instance, you might have bought the $100/$105 spread on XYZ. Well if XYZ closes anywhere above $105 you are ok because BOTH positions will be auto-exercised. This SOMETIMES results in a margin call as well -- but don't worry. Option clear throughout the day on Saturday and your account will frequently show one position and the other not exercised yet. By Sunday morning it will be fixed. By way of example, I had a very large position (for me) (20 contracts) in the LNKD 92.5/95 vertical call before earnings. Well earnings did what they were supposed to and LNKD jumped to 104. Well Saturday morning, all of a sudden, I was SHORT 2000 shares of LNKD and had received roughly $190K in cash into my account. This sends off all kinds of margin alerts. I got an email, a call, and another call. Ignore them. The 92.5 side simply hadn't cleared yet. Three hours later the other option cleared, buying the shorts back at 92.5. Then Sunday morning, your account statement will reflect that all trades happened at the same time.
HOWEVER, what if, on that 100/105 spread, XYZ closes at 103 on Friday? Well, guess what, you'll be assigned on the 100 position, the 105 will expire worthless, and now your back in margin call.
MORAL OF THE STORY:
DON'T EVER LET YOURSELF BE ASSIGNED ON A SPREAD THATS NOT FAR IN THE MONEY ON BOTH LEGS.
Image courtesy of https://www.projectoption.com.
What if, on Friday, the price of XYZ was at $106 at close? You better have closed the spread, because of after hours trading. The price of XYZ can move after hours -- but you can't get out of the options. So if the market closes at 106, and you say good, both legs will clear and I won't pay commissions (or pay less commissions) and get a huge tax break, you could be wrong, as in after hours the market might go back to $104.98. Then you're screwed, only the 100 option gets exercised and you go into margin call. I'm convinced when your near a strike the market makers manipulate the after hours markets to have this happen.
Of course if you have enough cash in your account, you won't get margin called -- you're risk profile will just be largely out of whack.
And this isn't to say you can't have a big benefit from this. My single most profitable trade EVER occurred on a spread that was $.50 above the line, I didn't close it, and then in after hours the price dropped. So I got assigned long on the lower strike. Well, that weekend there was big news involving the company and the price jumped 15% the next morning. In that case, here's what happens -- I own the 100 (long) /105 (short) vertical. After hours, the price is $104.92. Well that spread was worth $4.85 at close on 20 contracts, or $9,700. Well, Saturday I'm now the proud owner of 2,000 shares bought at $100.00 each, for a net cost of $200,000 -- oops. Margin call, broker call, broker email, etc. Well they inform me the trade will immediately close at open on Monday. Well the price jumped, and the position was closed, at $240,000.00. My original investment of $8,500.00, that I didn't want to close at $9,700.00, netted me $40,000.00, or roughly a 470% return. BUT, what if the price had gone down 20%? Well I would be owing my broker money and have completely blown out my account.
If you have ANY questions on this, please let me know.
Now SITUATION TWO -- and you will, sooner or later, encounter this. Let's say we have a 100(long)/105 (short) put spread on XYZ. Only we own the September spread and today (Friday) XYZ closes at 103. No big deal - UNLESS someone exercises their 105 option. American style options can be exercised at anytime. Why would this happen with time value? Who knows, most likely someone needed to unwind a position, hedge something, take profits, or any number of things.
Well if you had a 10 contract position, on Saturday your account is down $105,000.00 in cash and you are long 1,000 shares of XYZ. You will again likely go into margin call, unless you had over $105,000 in cash in your account. However, while this is a headache and you will have to deal with your broker, you don't need to panic because the position is still hedged.
So what happens here? Well when Monday rolls around ideally the price of XYZ has gone up. If it has, you sell the shares and keep the money. If the price has gone DOWN though, you stand to lose up to $5,000.00. You can't lose more than that because you still own the 100 puts. Depending on what occurs here, your broker might just auto-close the whole position, may allow you to exercise the 100 puts and have that resolve the situation, or may let you just sell off enough to get out of margin call. Different brokers handle margin violations differently. The good news is though your losses are capped.
When this happens, take your lumps and move on. I have this happen about once a quarter and my worse loss was 4%. There's nothing you can do to protect against this. You are hedged, and you won't blow your account out, but it does suck - particularly if the price moves down quite a bit at the open.
I hope that clears some things. If not, please let us know.
Christopher Welsh is a licensed investment advisor in the State of Texas and is the president of an investment firm, Lorintine Capital, LP which is a general partner of three separate private funds. He is also an attorney practicing in Dallas, Texas. Chris has been practicing since 2006 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. He offers investment advice to his clients, both in the law practice and outside of it. Chris has a Bachelor of Science in Economics, a Bachelor of Science in Computer Science from Texas A&M University, and a law degree from Southern Methodist University. Chris manages the Anchor Trades portfolio, the Steady Options Fund, and oversees Lorintine Capital's distressed real estate debt fund.
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By Mark Wolfinger
Jeff,
I am here to help you understand how options work, but am at a loss as to where to begin. I’ll explain in the simplest possible language. I am not talking down to you. I am trying to get you to move past a mental block.
Facts
Any time that an option is in the money (ITM) at expiration, expect that its owner will exercise. Even when it’s ITM by one penny. The option owner must fill out and submit a DO NOT EXERCISE form to prevent the Options Clearing Corporation from exercising ITM options Many beginners do not know they have the choice to not exercise
Many beginners forget they own the options or forget that expiration has arrived. As a result, they become owners of stock that they do not want, and cannot afford to purchase
Many beginners make mistakes. Let’s minimize yours.
Call strike price + premium paid = break-even
I’ve placed your equation in bold. It is of vital importance that you understand one thing about that equation:
This equation, all by itself, is the cause of your problem.
Forget it. It has no relevance on whether anyone exercises an option. Your formula is fine for keeping records, after the trade is closed. It is unimportant now. More than that. It is currently causing confusion and limits your ability to recognize the truth.
Q: Using such a formula, does it follow that when the stock price is less than the break-even, then the call would not be exercised? For example, if at expiration the stock was $15.05 and one had purchased the $15 strike for a $0.10 premium, it seems one would not exercise the option.
No, it does not follow. If you ignored your break-even equation, you would never ask this question. You believe the owner of your call option would throw away $5, just because it represents a loss! Look at it from the perspective of someone who owns 100 calls. They are worth $500 to the trader.
You are saying that it ‘seems right’ for trader would throw away $500 because he paid $1,000 for that investment. No one in his right mind would do that.
To clarify: Have you ever sold stock at a loss? Did you consider telling your broker to take the shares out of your account and to give them to some randomly chosen person? Instead of taking current value for your stock, you could have chosen to make them worthless to yourself. Surely you know not to do that. When taking a loss, you recover some money. Your money. This situation is no different.
You must not toss cash in the trash just because the trade is at less than break-even.
If you lost a $10 bill and the next day found a $5 bill, would you refuse to pick it up because your loss was a larger sum? This is exactly the same. You must understand this principle. I don’t know how to make it more clear. Those options are worth $5 apiece and only an idiot would elect not to collect cash for them. [Exercise is a different decision and trust me when I tell you that selling is better for you.] Whoever ends up holding those options will exercise at expiration.
There is a tiny [my guess is less than one chance in 10 million] that an option ITM by five cents would not be exercised by its owner. But, it remains a possibility. People do make mistakes.
Q: Yet I have read that options will be exercised if the stock price exceeds the strike price at expiration [MDW: this is only true for calls; for puts the stock must be below the strike], which it does in my example. It makes me wonder if there are other factors being considered by the call buyer. One rule, which I assume is adopted by the industry, is that all options in the money at expiration by $0.05 or more are automatically exercised, unless otherwise directed. What other factors could cause calls to be exercised below the break-even detailed above?
Yes, automatically exercised. The OCC does not care about break-even. Nor should you. Today the number is ITM by $0.01, not $0.05.
You want to know what other factors would make someone exercise when that exercise (or sale) results in a loss. Here’s the answer: MONEY.
When you invest or trade, it is inevitable that you will have losses. When you have a loss, you do not have to lose every penny. The trader is allowed to sell (or exercise) to recover some money. You probably understand that process. However, when expiration comes into the picture, you ignore what you know because you think about that break-even nonsense. When you fail to exercise (or sell), you allow the option to expire WORTHLESS. Why would you take zero for an option that you can sell for $0.05? Answer that one question (correctly) and you will understand.
How can the original cost matter? That’s your hang-up. That break-even is bothering you. Today, right now, you have a choice. Take $5 or take zero. It’s as simple as that.
Q: Perhaps my question was misunderstood. I discussed selling the call rather than at what stock price a call owner will exercise. I understand and agree with you that it is better to sell your call for any amount rather than let it expire. I also understand what you mean by saying the premium paid is meaningless. Yes, if your plan was to sell the call and not exercise it then the premium paid is meaningless in terms of deciding whether you are going to sell the call or let it expire.[MDW: If you understand that, then why are you asking?]
(However, the premium is not meaningless if you want to determine if your trading strategy is successful as it represents part of your investment.)
I did not misunderstand. The premium is meaningless, as you admit.
You continue to look at useless items. You think record keeping and evaluating your strategy play a role in this discussion. They play no role when it’s time to make a trade decision. They are used after the fact to see how well you did. [If you disagree, and I have no doubt that you do, that discussion is for another time]
Q: Also, I think you misunderstood my example when I said the stock price was $15.05 and I had a call with a $15 strike for which I paid $0.10. This was interpreted as the stock was trading at $15.10. Perhaps the price relationships I used in my example would not exist in the market. I apologize if I improperly set my example.
When you buy the call at ten cents, and eventually exercise, then you buy the stock at the strike price ($15) per share, but your cost basis is $15.10. You did not improperly set your example. Nor did I misunderstand.
Q: Even so, I am encouraged by how you ended your response: “In this scenario you should almost never want to exercise”. This indicates to me that the risk of owning the stock, plus the additional investment required, must produce a greater return than displayed in the example before exercising the call becomes likely (at least for you).
No, not for me. For everyone. You made an investment. You sought a certain return. You did not earn that return. so what? Today is decision time: You take your $5 or you don’t. ‘Return’ no longer applies.
You are confused because you are looking at too many variables
You are concerned with break-even. You are worried about whether your strategy is working. You think about producing ‘a greater return.’ NONE of that matters at the time when the call owner decides what to do with the options: sell, exercise, discard. You either take the $5 or you don’t. It’s that simple. There is nothing else to consider. The fact that you have irrelevant items on your mind is the reason this is a problem.
Q: I’m still left not knowing at what stock price / strike price combination calls are usually exercised. [MDW: Of course you know. When the stock is at least one penny in the money options are exercised.] I suppose as a buyer it would be when the stock price is greater than the strike price plus the premium. [MDW: NO]As a covered call seller it probably would be best to assume it would be when the stock price exceeds the strike price.[MDW: YES] Although this is not technically correct since a call’s price must be greater than zero to be sold, it’s probably good enough.
Calls are always exercised when they are in the money at expiration. Period.
There may be the occasional individual investor who correctly (for his/her situation) decides that exercising is too expensive because of commissions (and there were no bids when he/she tried to sell the call), but in general, all ITM options are exercised. That is all you or anyone needs to know.
Over the years, if (and only if) you can overcome your mental block, you may not be assigned a couple of times when the option is ITM by a penny or two. Just don’t expect it to happen.
Q: I appreciate your efforts to help me with my question. I’m sure when my covered calls expire next week I will have an even better understanding that can only come from experience. Thanks again.
You are welcome. However, your entire conversation was from the point of view of the call owner. As the call seller you will learn zero about the mindset of the call owner. ZERO.
You must open your mind, throw out your misconceptions, and the truth will be right there in front of you. This is not difficult. This is the easy part. If you cannot understand this, there is no chance you can ever learn to use options effectively.
Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
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Can Options Assignment Cause Margin Call? The Right To Exercise An Option? Options Expiration: 6 Things To Know Early Exercise: Call Options Expiration Surprises To Avoid
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