Credit Option Credit Spreads Assignment

Exercise, Assignment and Spreads

Posted by Pete Stolcers on March 10, 2009

Option Trading Question

Today Rick W. asks, “I don’t understand what I’m supposed to do when I have a spread and I get assigned on one leg of the trade.”

Option Trading Answer

This is an involved piece. First let me define two terms. Exercise is what the buyer of an option does. They use their right to buy or sell a stock at a specific price. Assignment is what happens to the seller of an option when they are forced to buy a stock or sell a stock at a certain price. If you are long an option you have rights, if you are short an option, you have an obligation.

Let’s say that you are short the 50 - 45 put credit spread and the stock (ABC) is trading at $43 - ouch. It doesn’t matter what you sold it for, this can’t be a good trade. If the 50 puts are trading for $7 (parity) you run the risk of being assigned. If the traders who are long the puts decide to exercise their right to sell the stock at $50, the Options Clearing Corporation (OCC) determines which firms will be assigned and each brokerage firm has a standardized lottery process to determine how the assignment will be allocated across the accounts. As long as the 50 puts carry some premium, this risk is minimal. The reason is simple, the owner of the puts can get more by selling them in the open market.

You come in one morning and you are long ABC stock via overnight assignment of the $50 puts. You have three choices. One choice is to sell the stock and sell the put again. Bad move. Never do this. The options are already trading under parity and now that the option is in play, you will probably get assigned again. The second choice is to exercise the 45 puts that you are long. This action allows you to sell an equal number of shares that you are long. If you were assigned on 5 puts and you are long 500 shares, you would exercise 5 of the 45 puts. Now you are “flat” the stock and if you do it the same day, you are exempt from having to put up the margin for the long stock (rule: same day substitution). This action makes sense if the stock is trading below $45. The third choice is to simply sell the stock in the open market if it is trading above $45. If it is done the same day, it also qualifies for the margin exemption.

If the risk scares you, you can always place an order to buy the spread in for $5. That is the max that it can ever be worth and you should not pay more than that no matter what the screen (bid/ask) shows. I do not advocate doing this because in essence you are giving someone a free call. They sell the spread for $5, the most it can be worth. If the stock reverses, they will participate in the rally - WITHOUT TAKING ANY RISK.

The risks and approach are much different for cash settled products like the OEX. That might be a future article. A stock that is closing right at the strike of the cheap leg of a spread on expiration Friday also creates a problem that will be covered in the future.

If you are having issues with a position this expiration, post a comment and let’s take a look.

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The bull call spread requires a known initial outlay for an unknown eventual return; the bull put spread produces a known initial cash inflow in exchange for a possible outlay later on.

Outlook

Looking for a rise in the underlying stock's price during the options' term.​

While the longer-term outlook is secondary, there is an argument for considering another alternative if the investor is bullish on the stock's future. It would take careful pinpointing to forecast when an expected decline would end and the eventual rally would start.​

Summary

A bull put spread is a limited-risk, limited-reward strategy, consisting of a short put option and a long put option with a lower strike. This spread generally profits if the stock price holds steady or rises.

Motivation

Investors initiate this spread either as a way to earn income with limited risk, or to profit from a rise in the underlying stock's price, or both.

Variations

A vertical put spread can be a bullish or bearish strategy, depending on how the strike prices are selected for the long and short positions. See bear put spread for the bearish counterpart.

Max Loss

The maximum loss is limited. The worst that can happen is for the stock price to be below the lower strike at expiration. In that case, the investor will be assigned on the short put, now deep-in-the-money, and will exercise their long put. The simultaneous exercise and assignment will mean buying the stock at the higher strike and selling it at the lower strike. The maximum loss is the difference between the strikes, less the credit received when putting on the position.

Max Gain

The maximum gain is limited. The best that can happen is for the stock to be above the higher strike price at expiration. In that case, both put options expire worthless, and the investor pockets the credit received when putting on the position.

Profit/Loss

Both the potential profit and loss for this strategy are very limited and very well-defined. The initial net credit is the most the investor can hope to make with the strategy. Profits at expiration start to erode if the stock is below the higher (short put) strike, and losses reach their maximum if the stock falls to, or beyond, the lower (long put) strike. Below the lower strike price, profits from exercising the long put completely offset further losses on the short put.

The way in which the investor selects the two strike prices determines the maximum income potential and maximum risk. By selecting a higher short put strike and/or a lower long put strike, the investor can increase the initial net premium income. However, it may be interesting to experiment with the Position Simulator to see how such decisions would affect the likelihood of short put assignment and the level of protection in the event of a downturn in the underlying stock.

Breakeven

This strategy breaks even if, at expiration, the stock price is below the upper strike (short put strike) by the amount of the initial credit received. In that case, the long put would expire worthless, and the short put's intrinsic value would equal the net credit.

Breakeven = short put strike - net credit received

Volatility

Slight, all other things being equal. Since the strategy involves being short one put and long another with the same expiration, the effects of volatility shifts on the two contracts may offset each other to a large degree.  

Note, however, that the stock price can move in such a way that a volatility change would affect one price more than the other.

Time Decay

The passage of time helps the position, though not quite as much as it does a plain short put position. Since the strategy involves being short one put and long another with the same expiration, the effects of time decay on the two contracts may offset each other to a large degree. 

Regardless of the theoretical impact of time erosion on the two contracts, it makes sense to think the passage of time would be a positive. This strategy generates net up-front premium income, which represents the most the investor can make on the strategy. If there are to be any claims against it, they must occur by expiration. As expiration nears, so does the date after which the investor is free of those obligations.

Assignment Risk

Yes. Early assignment, while possible at any time, generally occurs only when a put option goes deep into-the-money. Be warned, however, that using the long put to cover the short put assignment will require financing a long stock position for one business day.

And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as for example a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock.

Expiration Risk

Yes. If held into expiration, this strategy entails added risk. The investor cannot know for sure whether or not they will be assigned on the short put until the Monday after expiration. The problem is most acute if the stock is trading just below, at or just above the short put strike. 

Say, the short put ends up slightly in-the-money, and the investor sells the stock short in anticipation of being assigned. If assignment fails to occur, the investor won't discover the unintended net short stock position until the following Monday and is subject to an adverse rise in the stock over the weekend. 

There is risk in guessing wrong in the other direction, too. This time, assume the investor bets against being assigned. Come Monday, if assignment occurs after all, the investor has a net long position in a stock that may have lost value over the weekend.

Two ways to prepare: close the spread out early, or be prepared for either outcome on Monday. Either way, it's important to monitor the stock, especially over the last day of trading.

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Related Position

Comparable Position: Bull Call Spread

Opposite Position: Bear Put Spread

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