If you're selling options -- either as single contracts or as part of spreads or another strategy -- chances are, sooner or later you'll get hit with a hot potato: the surprise early exercise. Fact is, many traders have never planned for this possibility and feel like their strategy is falling apart when it does happen. How can you stay prepared and react to early exercise intelligently? Let's break down some scenarios. First, to the dictionary!
Always good to define our terms before really diving in. Options are really contracts conferring rights and obligations. The buyer of an option is paying for a certain right: to buy or sell a stock at the strike price. Option buyers -- those who are long the contract '“ hold the rights and therefore call all the shots. If a buyer decides to exercise those rights before expiration -- well, fittingly, that's called early exercise.
Now put yourself in the option seller's shoes, i.e. those who've shorted the option. Option sellers take on certain obligations and get compensated for that by the proceeds of the option sale. If you sell a call, you must be ready to sell stock at the strike price; if you sell a put, you stand ready to buy stock at the strike price. Again, as an options seller, you aren't running the show, because the options buyers have all the rights. Instead you may be subject to assignment: fulfilling on your contractual obligation if a buyer decides to exercise the contract.
End-games for optionsEveryone knows you can buy options, but the really great thing about the options market is that you can sell options without owning them, creating a short position (hence the reason for this post). Many know this but don't think about the big picture, that is, the various outcomes that can happen after the position is established and how often each tends to happen. So you've bought or sold options to open a long or short position. What now? There are three possible "end games", or results, of your trade.
1) The options are bought or sold to "close" the position prior to expiration.
2) The options expire worthless.
3) The options are exercised or assigned prior to or at expiration, resulting in a trade of the underlying stock.
A common misconception is that #2 is the most frequent result, but actually #1 is (That's why I listed it as #1 here).
If your option trade is working in your favor, you can choose to cash in. If, on the other hand, your trade is going against you, it's perfectly fine to cut your losses and close out the trade early. After all, you don't have to wait until expiration to "see what happens". Once an option is closed in the marketplace, it ceases to exist. That's why when you enter an order, it says buy or sell "to open" or "to close". The Options Clearing Corporation keeps track of those stats and displays them to the public as the figure called "open interest". If more of the trading volume is marked "closing" then the next day the open interest number deceases; if more volume is marked "opening" the open interest will increase.
For many options traders, the fact that 17% of options are exercised / assigned is eye-opening. This doesn't imply exactly 17% of your short positions will be assigned, but it is a big-enough figure to suggest that you if continuously have a short option position in your account, eventually you'll be assigned and sooner or later it will happen prior to expiration. If you are short an option, the only way to assure that you will not be assigned is to buy to close the position, thus removing your obligation.
What happens at assignment, anyway?
"Assignment" happens via a random lottery system run by the Options Clearing Corporation (OCC). When the OCC receives an exercise notice, it's assigned randomly to a member firm -- possibly your brokerage firm. Your broker in turn assigns exercise notices to short options positions, either randomly or on a "first-in, first-out" basis.
American versus European
When we talk about early exercise, we're always talking about so-called "American-style" options. European-style options can only be exercised on the last trading day before expiration, so early exercise isn't an issue for them. American-style options, on the other hand, can be exercised anytime, from immediately after purchase, right until expiration.
As of this writing all equity options traded in the U.S. are American-style, as are some index options like the OEX (S&P 100 Index). Most indexes are European-style, including the DJX, SPX, XEO, and MNX. As for options based on Exchange-Trade Funds (ETFs), there's no hard-and-fast rule - it depends on the individual contract. Before you set up a new position, it's critical to know whether the options you're using to construct it are American- or European-style, so you know if early assignment could happen to you.
Getting a leg pulled out from under you
By now you may be duly alarmed about the dangers of early exercise, so let me put this danger back into perspective. Early exercise can affect all options sellers, but it's more of a concern for advanced option traders using multi-leg strategies like long and short spreads, butterflies, long calendars and diagonals. (The latter two strategies are probably most vulnerable to early exercise risk.)
I'll get into more detail about why this is such a problem for multi-leg traders later in the series. For now, just imagine carefully setting up a multi-leg trade with a specific outlook in mind, then waking up one morning to an assignment that suddenly throws long or short stock into the mix, where once an option stood. Suffice it to say, getting a leg pulled out from under you can change the entire outlook of your trade. It's useful in those moments to have some sense of how you might switch gears, if this happens.
The plot thickens...
In my next post we'll talk about some factors that may up your chances for early assignment. Those factors differ slightly depending on whether you're selling calls or puts, so we'll divide the discussion accordingly.
Later we'll get into some math that may help predict early exercise. Essentially, the option buyer uses certain synthetic relationships and the cost-to-carry to decide when conditions are right to exercise. I'll show you a few calculations to make that decision clearer from the buyer's perspective -- which makes you that much more ready to act as a seller if you're assigned.
Regards,
Brian (OG)
[image: Hot Potato I by 3rd foundation on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
