Welcome back to my blog series on early exercise! Sorry for the delay in getting back to this series – lots of travel and other obligations intervened. But I’ve been getting great feedback from you about this series, so I’m glad to have the chance to get back on track. So far in the series we’ve defined early exercise and hopefully convinced you it’s a fairly common occurrence worth factoring into your plans. We’ve also reviewed some general factors that might up the chances of early exercise and assignment on your shorts; we’ve also calculated cost-to-carry and chatted about synthetic relationships that often drive the option owners’ decision to exercise (or not). 

This week we discuss assignment risk to spreads, with a special emphasis on calendar spreads. It’s so easy to tee up the perfect spread, only to be exercised against, lose the short leg – and not know what hit you, or what to do next. Sound familiar?

The tough fact here remains: if you’re short an option, you are not in control of early exercise – the option buyer is. We’ll run through some scenarios that may help you weigh the odds of your chance of getting assigned, but keep in mind that people aren’t always rational. Option buyers will occasionally exercise in scenarios where it makes absolutely no sense to do so, and there’s really nothing you can do to eliminate that risk entirely. What you can do is what we’ll discuss today: tee up spreads intelligently, with an awareness of the possibility of early assignment, and review a considered plan for how you’ll react if it does, indeed, happen to you.

Remember: calls and puts are not equally at risk for assignment

You may recall from previous posts that calls and puts pose different degrees of assignment risk. In general, puts are more likely to be assigned early than calls, simply because of human nature. In brief: call exercise requires the call owner to BUY stock, using cash to do so, whereas put exercise means the owner must SELL stock, putting cash info the account. Receiving cash now is often more appealing to investors than spending cash now, largely explaining why puts are more likely to be assigned early than calls.

There is one IMPORTANT exception to this rule: when there’s an upcoming dividend, it will entice many call owners to exercise in order to snag it. Call owners aren’t entitled to the dividend unless they become stock shareholders in time. For this reason, many call owners might exercise a call before the ex-dividend date to become the shareholder of record and receive the dividend. This same dividend reduces the chance a put owner would exercise just prior to the ex-dividend date. If a put owner exercises and does not own the stock she or he would be short the stock and then be obligated to pay the dividend.


Out of balance

I’ll be focusing on long calendar spreads below, but keep in mind that the same assignment risks and recovery strategies apply to vertical spreads, too.

When constructed with calls, long calendar spreads are often billed as a low-risk strategy. Here’s how they’re built in a nutshell: You sell a front-month call on XYZ at the 50 strike, say, and then buy a back-month call on the same underlying, also at the 50 strike. Now you have an obligation to sell stock (if necessary) in the front-month period, balanced by the right to buy stock (if you choose) at the same strike in the back-month period. It all sounds like it’s in perfect balance, and it can be – but it’s not guaranteed to be so. The trade is usually done for a net debit, and many textbooks will tell you the most you can lose is that debit amount – which is not true for American-style options that can exercise at any time before expiration. Currently all stock options trading in the U.S. trade American-style, which means they all carry this early assignment risk.

To paint this picture, let’s imagine that stock pays a big dividend – 50 cents - a week before the front-month option contract’s expiration date. Your short call might get assigned, because the call owner is enticed into capturing that dividend and the cost of carrying the stock is less than the time premium left in the call. (Learn more about cost-to-carry considerations in my previous post.) If that happens you’d have to supply that stock at 50 to the call owner (leaving you short the stock before the ex-dividend date). If you’re short stock you’d also have to pay that 50-cent dividend to the owner of the stock you shorted. Suddenly the balance of your calendar spread is out-of-whack: you really sold the stock for 49.50, and have the right to buy it via the back-month option at 50. That 50-cent risk in the middle unfortunately can’t be avoided in this example.

(Another annoying thing for traders who’ve never been short stock around a dividend before is that payment of the dividend to the stock owner is not instant. A month or more can go by after the ex-dividend date before you see that dividend debit you paid to the shareholder hit your account. By then you don’t even have the short stock position, so you’re left wondering: “What’s this new debit in my account?” Well, it might be cold comfort – but at least now you’ll understand why!)

Many traders’ first urge is tinged with either panic or vindictiveness: exercise the back-month and get even at Fate! Well, that might give you some momentary emotional satisfaction, but it’s not a particularly smart move, since exercising the back-month means you’ll lose the extended time-premium (if there is any) in this leg. Often it’s a smarter move to close out the back-month position by selling the long leg on the open market, then buying the stock as soon as possible on at the market. The move still captures the time premium of the back-month call while removing the short stock risk created by the assignment. If this does happen, I’ll be honest with you: it’s not a good scenario for the long calendar spread trader. You could lose more than you initially paid for the long call spread if the dividend is large enough.

Your “damage-control” strategy for short call calendars and vertical spreads is pretty similar to what’s outlined above: don’t panic. Anticipate dividends as a driver for potential assignment, and try to close out the whole position where you can.

Think of assignment risk to calendar spreads like playing on the city streets: It’s better to get out of the way when you first see the car than it is to hope the driver sees you and decides to stop or swerve.

Translation into options-terms: if you do decide to take the gamble, keep an eagle-eye on when that dividend is paying out. If the short front-month is in-the-money and expiration is approaching, beware: it’s usually better to close the whole spread before an assignment can mess it up than it is to hope you’re not assigned and then have to react after the fact.  Your next best move might be not to play in the street at all - avoid putting calendars on for large dividend-paying stocks, especially if the ex-dividend date is near the expiration date of the front-month option.

The flip side: put calendar spreads

As I mentioned before, put assignment risk is driven by different factors than those affecting calls. If there’s a dividend being paid out on a put, that’ll actually work as a deterrent to assignment, because put owners usually don’t want to exercise before the ex-date and be short the stock, requiring them to pay out the dividend. That said, whenever a put starts to get deep in-the-money and the options value is becoming all intrinsic value and has very little time value, the risk of early assignment will be there. If it happens, don’t panic and exercise the long back-month option right away. You might be able to eke out a few nickels or dimes by selling the long option and at the same time selling the stock that was put to you on the open market.

Next time...

...we’ll be diving into what’s called “exercise pin risk”. Pin risk strikes short options traders right around the last moment of trading on expiration Friday. In short, it’s the unknown risk of being assigned when the stock trades right at your short strike. It’s definitely useful to have thought this scenario through before you’re in the heat of action.

Until next time!
Regards,
Brian (OG)
[image: Egg Target by blip on flickr]

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