When you sell an option as part of a multi-leg trade with two expiration dates, what’s the best way to exit the position? Today’s post takes a real-world client question and helps you better weigh your options when trading complex option strategies. Today’s Grab Bag question comes from a TK client. He describes a diagonal spread he put on recently in Frontline Ltd (FRO):
Sell Aug09 FRO 30 calls
Buy Jan10 FRO 25 calls
FRO now trading around 24
His question goes like this: “If the option expires out-of-the-money (OTM), I will keep the premium. If it expires in-the-money (ITM) and I receive an assignment notice, do I have to physically exercise the Jan 10 to be able to deliver the shares at 30 per the assignment? Or does TradeKing handle the whole transaction, and I would end up with the 5pts minus commissions?”
Let’s work backwards and address the second part of the question first: never assume a brokerage firm is going to do anything automatically for you. Always call and let them know what you’re thinking. All brokerage firms prefer that you call the shots as to what happens in your account, especially as expiration nears and you may be in danger of getting assigned. With options, there are often many choices, and that’s definitely the case with this trade. We’ll actually be addressing a different way to exit this trade than the one proposed in the question.
Let’s set up this trade for those who may not be familiar. This play involves the sale of an out-of-the-money (OTM) call with a near-term expiration – that’s the Aug09 call at 30. The second leg involves buying an at-the-money (ATM) call with an expiration that has an expiration further out in time – that’s the Jan10 25 call above.
The max potential risk of the trade by the first expiration date is the net debit paid, the price paid for the long option minus the credit received from selling the call.
You’ll hit this trade’s sweet spot if the underlying – in this case, FRO – rises to 29.99 by the front-month (Aug09) option expiration, at which point you’ll be able to keep the premium you collected from sale of the 30 call and still hold the longer-term option. The break-even point is a little tricky to calculate for this play, because the two options have two different expiration dates. Your best bet is to pop the trade into our Profit + Loss Calculator and fast-forward to the front-month expiration, Aug09.
(Keep in mind that multiple-leg options strategies involve additional risks and multiple commissions and may result in complex tax treatments. Consult with your tax advisor as to how taxes may affect the outcome of these strategies. One last caveat for the example above: we’ve calculated this imaginary projected return and simplified matters by disregarding account expenses like commissions, fees, interest paid on margin, or taxes; in the real world, you should factor costs like these into your calculations. This example also assumes none of the options mentioned get exercised or assigned before expiration – but in the real world, that can happen, so plan accordingly.)
So much for the trade setup; let’s move on to RedState’s question. If you do get assigned on the short call, it usually makes the most sense not to exercise to the longer term (Jan10) call to make good on your delivery of the stock. Usually it’s best to sell the long call on the open market and capture any remaining time premium, along with the intrinsic value.
In case you’re unfamiliar, the intrinsic value of an option refers to the amount, if any, that option is in-the-money. Time value or time premium, on the other hand, refers to the portion of an option price that’s based purely on its time-to-expiration. For ITM call options, the total options price minus the intrinsic value will result in what is consider to be the “time value” of the option contract.
After selling the Jan10 call and capturing that time premium, then you can buy the stock on the open market, which you will then be required to deliver to make good on the obligation you assumed when selling the call. The closing sale of your longer-term call and the purchase of the stock should lower your net overall cost of the stock purchase in the end. The amount of benefit depends on how much time value remains in the longer-term call.
Many of the same dynamics are in play with exiting this trade as LEAPS-based covered calls – check that post out for more info.
Just to reiterate: you need to pull the trigger on these orders, not the brokerage firm. It pays to have a broker that really understands options when executing this maneuver, so feel free to contact us at TradeKing and we’ll help you through the process.
Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com
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