Q&A

Explore Your Options

with Tom Gentile

Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.

EXERCISE FOR FINANCIAL HEALTH?
When is it a good time to exercise a long put?

That’s a good question, but kind of a broad subject. In theory, traders look to exercise a put when the carrying cost to hold a combined long stock/long put (that is, a long synthetic call) is greater than the value of the actual listed call market.

This decision to exercise typically occurs when the put is deep enough in the money and the matching strike call maintains little or no extrinsic value. For instance, let’s say an out-of-the money call has a quoted market of $0.00 bid/$0.05 ask. At the same time, if the cost of carrying the synthetic call or married put amounts to $0.10 if held until expiration, there’s a negative benefit to holding that position versus simply purchasing the long call.

A related consideration that affects directional traders is choosing between exercising or selling the put in the open market when he or she is ready to exit the position. If the sale of a put adds value above parity versus what we would be faced with by exercising the put, the former makes sense, likely in the form of a few added cents or pennies.

OUT OF TIME WITH A CALENDAR?
I’ve been looking at long calendar plays as a bread & butter strategy but would like to know if I could get assigned since I executed the position as a spread. If so, what would the ramifications be and how might I prevent this from occurring?

The answer to your first question is an unequivocal “yes.” It’s entirely possible to receive assignment on the short leg of your long calendar or any spread involving short contracts for that matter. Whether your short call or put is assigned is another story altogether. In general it’s not a situation to fear, as it could turn out to be profitable and something that’s easy enough to prepare for.

When dealing with a long call calendar, a trader is unlikely to receive assignment prior to expiration, as the cost to hold a long call (the other side of your contract) is substantially cheaper than the equivalent long stock commitment.

There are two caveats that traders need to be on guard for. The first is if the stock is about to go ex-dividend and the call’s pricing makes it a likely candidate for exercise so the trader can collect the payout. The other situation would be if the underlying stock is or could become hard to borrow (Htb).

For more information on those situations, I covered both issues in this column back in October 2009. With a put calendar, traders can consider the potential for assignment by referring back to our first topic regarding when a long put holder might be compelled to exercise his or her contract.

In situations other than Htbs and imminent ex-dividends, if a trader is long a call calendar and receives assignment, the adjusted position becomes a synthetic long put but whose risk is still the initial debit paid. At the same time, the reward profile maintains the possibility of much larger gains than with the long calendar in the advent of a drop in the price of the underlying stock. There’s also a strong chance that the position will be immediately profitable at current levels, all else staying the same.

To illustrate, let’s take a look at a couple scenarios involving Research In Motion (Rimm) from mid-June and shares priced at $59.32. With four days left in the June contract, an in-the-money July/June 55 call calendar was priced $1.83 mid-market. At the same time, the June 55 put could be traded for $0.16 while the July put was changing hands at $1.97.

If assigned on the short call and converted into short stock along with the long July 55 calls in inventory, the trader holds the synthetic equivalent of the July 55 put for $1.83. If Rimm opened unchanged the next day and volatility remained unchanged, the position would be profitable by $0.14 or the difference of what the actual long July 55 put was trading for.

An extreme and very unlikely case but one that brings home the point of a very pleasant assignment would be if a trader were long the “mostly” at-the-money July/June 60 call calendar. Priced for $2.46 per spread, if the trader were fortuitously assigned, he or she would be synthetically long the July 60 put, which traded for $3.90 or a paper profit of $1.44.

No doubt about it, such an assignment scenario would be a fluke, as the call was slightly out-of-the money by $0.68 and maintained extrinsic value of $0.82. Adding the two together and looking at the paper profit from a different angle, the trader’s good fortune is essentially the same as taking in (that is, selling) the premium of the June 60 put, which traded for $1.48, but not having to take on the risk of being short the contract.

In essence, any profit collected on the assignment is going to mostly match any existing extrinsic value left in the same “strike listed” put market. For a put calendar, the trader is performing the same type of paper profit math but focused on what the same strike back-month call is trading for relative to the “new” synthetic long call purchased for the cost of the calendar.

Assignments on either type of calendar would be typically desired by traders because of the strong potential for quick profit while the capital at risk remains the same. Traders would, however, be forced to deal with new higher margin requirements and ultimately, new risk issues of direction, time decay, and implied volatility that are associated with being long either a put or call versus holding a long calendar position.

Contributing analysis by senior Optionetics strategist Chris Tyler.

Return to Contents