What happens to your spread at expiration?

optionsguy posted on 05/20/10 at 02:54 PM


Today's post explores a question frequently asked by new options traders: what can happen to your options spread at expiration?

I got a great question from TK client 96V4Z9PHB9, who was kind enough to let me share my answer in an Options Guy post.

"Brian, I consider myself a beginner option's trader and have never trader any kind of a spread. Regarding the Long Call Spread where I am buying a call and selling another, what happens at expiration if I am assigned? Will I have time to go buy the stock and place it in my account based on the call option I bought? Or should I even be concerned about that? Thanks."

Exercise and assignment are always a concern, so it's smart to understand these concepts.

To explain this, I need to introduce an important middleman in the options world: The Options Clearing Corporation (OCC). The OCC handles options exercise and assignment transactions. When you elect to exercise a long option, the exercise instructions go to the OCC (via your brokerage), so that a short contract holder can be assigned. If the two legs of the long spread are in-the-money (ITM) at expiration, they should be auto exercised by the OCC.

The auto-exercise process is more accurately described as “exercise by exception” because an individual can send instructions to the OCC via his or her broker to “opt out” of the auto-exercise process for specific contracts. A customer can send instructions to the OCC, via their broker, not to exercise such in-the-money options. If option owners do not send specific instructions NOT to exercise the OCC will auto-exercise a long option position in an account that is in-the-money by $0.01 or more at expiration. Option expiration is the Saturday following the third Friday of the month (the specific expiration date typically appears in your account with the security description). The auto-exercise test is applied to option contracts that were not sold by the last trading day and are $0.01 or more in-the-money, based on the last trading price for the equity during regular hours trading.

Since you said you're buying a long call spread, let's imagine you bought the 50 call and sold the 55 call. This is a bullish play, in which you're hoping the underlying moves at or above 55 by expiration. Your potential profit is limited to the difference between the strikes (55-50), minus whatever net debit you paid. Your risk is limited to that upfront debit paid.

If the 55 call ends up in-the-money (ITM) at expiration, the 50 call will be way ITM. So upon expiration the Options Clearing Corporation (OCC) would exercise the 50 call for you; you would buy stock at 50 and then sell it at 55 via the assignment of the 55 strike call option.

That's basically the process at expiration. Since you're new to all this, it's important to note that early exercise and assignment only impacts American-style stock options, which can be exercised anytime PRIOR to expiration. (This makes them different from European-style options, which can only be exercised AT expiration.) Learn more about American- versus Euro-style options here.

You should also read up about early exercise and assignment. This page from the OptionsPlaybook.com includes factors that may increase or decrease your likelihood of getting assigned early on your short option positions.

Thanks for the great question!

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

[image: KitchenTimer01 by hickr on Flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.

Spreads are multiple-leg options strategies involving additional risks and multiple commissions and may result in complex tax treatments. Keep the risk of early assignment in mind when constructing your own trades. Consult with your tax advisor as to how taxes may affect the outcome of these strategies.

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Posted by optionsguy on 05/20/10 at 02:54 PM

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