Exercise/Assignment

[cwelsh 1,497]

I've had three emails in the past month on people being assigned on positions and receiving margin calls, and generally not knowing what happened. I advise everyone to completely research and become familiar with the exercise/assignment aspect of option trading. 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 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 ( 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 frequenltly 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 statment 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:

DONT EVER LET YOURSELF BE ASSIGNED ON A SPREAD THATS 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 afterhours 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 occured 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, Satruday 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, ect. 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, enounter 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 realy.

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, whie 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 mid point 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 fluctutae 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 .

[Kim 7,475]

Chris, this is an excellent explanation, thank you.

[Guest tkast36]

Chris, Thanks for the detailed explanation. Since I have only been trading options for less than a year, I've been sticking to Straddles, Strangles and some directional trading. Selling Calls/Puts (other than Covered Calls) scares the crap out of me. I wish I had more time to learn. Just to clarify, is below correct:

Selling Puts+Assignment=I'm Long the Underlying Stock.

Selling Calls+Assignment=I'm Short the Underlying Stock.

[Kim 7,475]

Yes.

[cwelsh 1,497]

Chris, Thanks for the detailed explanation. Since I have only been trading options for less than a year, I've been sticking to Straddles, Strangles and some directional trading. Selling Calls/Puts (other than Covered Calls) scares the crap out of me. I wish I had more time to learn. Just to clarify, is below correct:

Selling Puts+Assignment=I'm Long the Underlying Stock.

Selling Calls+Assignment=I'm Short the Underlying Stock.

As Kim said, that is correct. I wouldn't be scared of the vertical spreads and/or calendars -- by and large they are "safer" as they are a purely hedged position. There is a maxium loss on each trade, unless you don't close prior to expiration. Though, I would encourage you to paper trade and read about them until you understand them. Pretty much all my major early losses came from things I didn't understand (like that RUT closes on a different day for a "calculated" value, or that on indexes the values can be "readjusted" over the weekend).

[Guest tkast36]

Thank you both. With the statement, " I wouldn't be scared of the vertical spreads and/or calendars -- by and large they are "safer" as they are a purely hedged position. ", would that also apply to ICs and RICs, in your opinion?

[cwelsh 1,497]

Thank you both. With the statement, " I wouldn't be scared of the vertical spreads and/or calendars -- by and large they are "safer" as they are a purely hedged position. ", would that also apply to ICs and RICs, in your opinion?

absolutely -- all ICs and RICs are is a double vertical spread. Instead of just having the call side, you have the put too.

[Guest listolyman]

Yes. IC's and RIC's are structures that contain 2 vertical spreads( a call spread and a put spread)

[hansheng 0]

Thanks for your sharing Chris.

[cwerdna 12]

Chris, Thanks for the detailed explanation. Since I have only been trading options for less than a year, I've been sticking to Straddles, Strangles and some directional trading. Selling Calls/Puts (other than Covered Calls) scares the crap out of me. I wish I had more time to learn. Just to clarify, is below correct:

Selling Puts+Assignment=I'm Long the Underlying Stock.

Selling Calls+Assignment=I'm Short the Underlying Stock.

There was a great table in some Investools training (I shouldn't put it up, since it's copyrighted) but the first table at http://www.optionmon...ions_basics.php is similar to it, discussing right and obligations, depending on your position (buyer/seller) and put vs. call.

If you sell a naked put, your max loss is capped at the (strike price * 100) - premium received. So, if you sold a put at a 100 strike, and received $500 premium, and the stock fell to $0, if you hold it until expiration and it expires ITM, you're going to be assigned 100 shares at $100/share, so you're going to pay $10,000 for stock that's worth $0. But, you did receive the $500 premium, so you lost $9,500.

If you sell a naked call, your max loss is potentially infinite. Let's say you sell a naked call on a stock at $100 strike. Since it's naked call, you don't have any to cover it. If the stock hits $1000 and you're assigned, well, you've got to buy shares on the open market at $1000/share to give to the other guy but only be paid $100/share.

If you use Thinkorswim, in the options buy/sell confirmation dialog, it'll tell you your max loss and max profit for most options trades. There are some types where it won't but for selling or buying calls or puts, it will.

I'm an options amateur too, and I'm not scared of selling way OTM naked puts on stocks that I wouldn't mind owning that are no more than ~50 days way from expiration. I've made a decent amount of $ (but use up a LOT of buying power) and have almost never lost $. One MUST be careful about earnings though. I almost never ever sell naked puts that expire after earnings. I just don't enter the trade and wait for earnings to pass.

I have never sold any naked calls yet. I'm scared by that.

Back to assignment, another consideration for some (depending on brokerage and position size) is the assignment/exercise fee, if any. For TD AM/TOS, on small positions, being assigned can suck. See http://steadyoptions...ade/#entry6183. It's best to contact your brokerage to understand what will happen when assigned, esp. if multiple legs expire ITM.

Edited August 11, 2012 by cwerdna

[Guest DShaver]

Chris,

Great article thanks for putting it out here. One question though. I was on the phone with TD a few months backs with one specific question in mind: which price is used to determine the .01 ITM for options on the day of expiration? (i.e. the After Hours price or the close) The guy from TD told me that it is whatever the closing price is Friday afternoon. I know from experience that not everyone answering phones at a brokerage knows an awful lot, but I was talking to someone in the options department. Now you're saying that the after hours price is what counts, that confuses me. I'll think I'll call back TD and try to find someone higher up the food chain to get clarification so thanks.

[cwelsh 1,497]

Chris,

Great article thanks for putting it out here. One question though. I was on the phone with TD a few months backs with one specific question in mind: which price is used to determine the .01 ITM for options on the day of expiration? (i.e. the After Hours price or the close) The guy from TD told me that it is whatever the closing price is Friday afternoon. I know from experience that not everyone answering phones at a brokerage knows an awful lot, but I was talking to someone in the options department. Now you're saying that the after hours price is what counts, that confuses me. I'll think I'll call back TD and try to find someone higher up the food chain to get clarification so thanks.

Whoever told you that is 100% wrong. It's the FINAL trading price on the day, which includes after hours trading (and actually thats not always 100% true, some stocks/indexes are treated and settle differently, see RUT for example). I learned this the hard way very early on, and it's also why volatile stocks, on expiration day, can still have SOME time value left in the premium when the markets close.

[Kelly Park 10]

I haven't had it happen to me, but I always worry about having the short leg of a calendar excersized early. Especially since most brokers don't seem to recognize the long leg as the hedge to the short leg. Have you had that happen Chris? Do you handle that the same way as the other early excercises? (Beg to close the long leg yourself.)

[cwelsh 1,497]

I haven't had it happen to me, but I always worry about having the short leg of a calendar excersized early. Especially since most brokers don't seem to recognize the long leg as the hedge to the short leg. Have you had that happen Chris? Do you handle that the same way as the other early excercises? (Beg to close the long leg yourself.)

I have never been assigned one leg on a calendar, but that does not mean it can't happen. However, it is unlikely, and if it occurs, unless you get a large adverse move in the underlying, you should still be able to get out.