Can you explain what extra risks I would assume with a long butterfly position if assigned on any or all of my short contracts?
Great question. First, realize a forced assignment in a long butterfly position won’t open up the trader to more dollar risk. The assumed debit and maximum dollars at stake when the position was opened remains the same, no matter how many of your short calls or puts are assigned. This is because you are hedged and contract neutral.
Understanding you are essentially in a covered position, as far as dollars at risk are concerned, might be easier if you break down the long butterfly into its component spreads of one bull vertical and one bear vertical and look at different assignment scenarios.
To illustrate, assume you have a one-lot XYZ 30/35/40 (1 x −2 x 1) long call butterfly established for $1.50. With shares at 37, you receive assignment on one of your two short 35 calls. Now short 100 shares as part of your overall position, you can exercise the long 30 call to flatten the stock inventory. The exercise, which is your right to buy 100 shares at 30, maximizes the value of the 30/35 bull vertical as you were already forced to sell or short shares at 35.
But maximizing your gain on one side of the fly isn’t the same as a guaranteed overall profit, but your risk remains fixed at $1.50. Now, into expiration or until you exit, you still maintain five points of risk on the open 35/40 bear call spread. In effect, this counters the closed bull vertical until and if you do better for yourself by buying to close the spread for less than $5. That’s possible, but with the worst-case scenario being a profit wash after closing out the two spreads, you remain on the hook or at risk for up to the initial debit paid of $1.50.
The real risk with early assignment is tied to the extra margin, which would be required to be in place due to the shorted or long stock or if your account isn’t qualified to hold short stock, such as with IRAs. In either situation, you would be forced to close down the position prematurely. If the closing of the position is transacted through the exercise process, the result would be a quicker-than-expected realization of your maximum loss potential.
However, if your broker’s rules allow you to close out the position in the open market and the capture of time premium is possible when exiting, your long contracts being closed would stand to benefit. This could result in a smaller net loss than experienced with exercising. And some profitability but less than the maximum associated with the stock landing at the short strike at expiration is possible.