Explore Your Options
| 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. |
Tom Gentile of Optionetics |
EXERCISE AND ASSIGNMENT
I hear the terms "exercise" and "assignment" used interchangeably, but don't they have different meanings?
Exercise and assignment are two sides of the same coin. The terms are used when an option owner decides to take advantage of the terms afforded by the options contract. For a stock option, exercise and assignment involves the transfer of shares from one party to another. For futures options, it involves the transfer of a futures contract. For index options, cash changes hands.
The difference between exercise and assignment is that the option owner is the one exercising their right to buy or sell the underlying asset. The option seller is the one being assigned. For example, I own January 50 calls on XYZ Corp. I can exercise my contract and buy, or call, XYZ shares from the person short the XYZ January calls. If so, the option seller has been assigned and must deliver XYZ at $50 a share.
TIME PREMIUM, EARLY ASSIGNMENT
What is the minimum time premium for short call, short put, or short leg for both vertical and credit spreads in order to avoid any early assignment or even remotely getting close to assignment? Is there less chance of assignment on short leg strike in a vertical spread than in a credit spread?
If you are short an option, another party is long that same option because an options contract is always an agreement between two parties. As a result, it is impossible to know when assignment will occur on a short option because the options owner, or the one that holds the other side of the trade, is the one who will decide whether the option will be exercised. The contract gives them the right to exercise the option.
As an options seller, you are obligated to honor the terms of the contract, but you are not a decision-maker. It doesn't matter whether you are short a put, a call, or short the option as part of a spread. The risk of assignment on any short option will be the same regardless of other positions held.
However, while there is no way to anticipate assignment ahead of time, there are some situations when it is logical. For example, before a stock pays a dividend, it might make sense for the option holder to exercise a call option, buy or "call" the stock, and collect the dividend.
In addition, when an options contract has little time value remaining, which generally occurs when the option is in-the-money and/or near expiration, the risk of assignment exists. As a rule, when the time value slips to 25 cents or less, the strategist should consider the possibility that the short option might be assigned. To compute the time value of an in-the-money option, strategists can use the following formula:
If you are unsure if the risk of assignment exists but want to avoid that possibility, the best course of action is to close the trade. You can close a short position by purchasing an options contract with the same specifications. For example, if you are short 10 XYZ March 50 calls, you will want to buy 10 Xyz March 50 calls "to close."Call option price + Strike price - Stock price = Time value Time value for an in-the-money put option is computed as: Put option price + Stock price - Strike price = Time value
LOSE-LOSE?
I have a call and a put on a stock that went in my direction about $2.00. I had the same strike price and month for both a call and a put to see what would happen. The price of the option went down on both the call and put. Why?
That position is a straddle. It involves the purchase of a put and a call on the same underlying stock. The puts and calls are purchased at the same time and in the same quantities. The puts and calls also have the same strike price and expiration date. The goal behind the straddle strategy is to make profits from a significant move in the underlying stock. If the stock makes a big move to the upside, the calls will generate profits. On the other hand, if the stock plunges, the puts will increase in value.
In the absence of a big move in the stock, however, the straddle is a losing trade because of time decay. Puts and calls have fixed lives and will lose value with the passage of time. For that reason, options are referred to as "wasting assets."
Another factor that might negatively affect a straddle is implied volatility (IV). Computed using an options-pricing model, IV is one of the factors that determines the value of an options contract. IV changes over time as expectations about the future volatility of the stock changes. Options on an underlying stock expected to exhibit high levels of volatility will be more expensive than one with low volatility because there is a greater chance the options contract will be in-the-money when the stock is making big moves.
When IV is high, the premiums are priced for a big move in the underlying asset and the options are considered expensive. This can occur ahead of an important event like an earnings report or a shareholder meeting. Once that event has passed, implied volatility will usually fall, which is known as a volatility crush. If a strategist buys a straddle when IV is high, both sides of the trade (the puts and calls) can lose value if IV falls and the position suffers from a volatility crush. It is better to buy a straddle when implied volatility is low and expected to rise. We offer charts and data on implied volatility on www.optionetics.com.
Originally published in the April 2007 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2007, Technical Analysis, Inc.
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