One of the more popular strategies among individual investors is covered call writing: the investor buys 100 shares of stock and sells one call option, granting someone else the right to buy that stock at a specific price, known as the strike price, for a limited time. Often, the option expires worthless and the investor keeps both his or her stock and the option premium. (If you need a quick refresher on this strategy, see The Basics Of Covered Calls.)
However, sometimes the option owner exercises the option and the investor is assigned an exercise notice, obligating him or her to sell the stock. This achieves the maximum profit available when writing covered calls.
Unfortunately, too many investors fear being assigned that exercise notice. Because they are uncertain, they may believe someone cheated them because the stock is trading above the strike price.
There is no rational explanation for that fear. In fact, being assigned early can sometimes benefit option investors except in one case: OEX options. Read on to learn more about early exercise and why OEX is the exception to the rule.
Here's the hard truth: Being assigned an exercise notice is nothing more than a notification that you fulfilled the obligation you previously accepted when selling the option contract. If you own stock that you don't want to sell under any circumstances, then you shouldn't be writing covered calls.
If you trade spreads (buy one option and sell another), then being assigned an exercise notice does not adversely affect your overall position. You lose nothing.
In fact, assuming your account has sufficient margin to carry the position, receiving an assignment notice before expiration can turn into free money on occasion because of additional profit potential. In other words, if the stock suddenly drops below the strike price, every penny of that decline below the strike is extra cash in your pocket - cash that you couldn't earn if you were short the call instead of stock.
The OEX Exception
The above is a rather lengthy explanation of why being assigned an exercise notice should never be a concern.
But, as mentioned above, there is one important exception - and that occurs when you sell OEX options. These options are cash-settled, American style options. All other actively traded index options are European style and cannot be exercised prior to expiration. (To learn more, read Exploring European Options and American Option Investors: Should You Go Euro?)
Why is OEX an exception? And what's the big deal about being assigned an exercise notice before expiration arrives anyway? Didn't we just learn that the individual investor shouldn't fear early assignment?
When using equity options, if you are assigned on a call, the option is canceled and, instead, you become short 100 shares of stock (or you lose 100 shares of stock that you own). As such, your upside risk is unchanged, but your potential downside profit is increased.
Everything changes, however, when you are assigned early and the option is cash-settled. Let's take a look at why this happens:
- When assigned on a cash-settled OEX option, you are obligated to repurchase the option at last night's intrinsic value. (We'll take a look at how this works in the example below.)
- You don't learn that you have been assigned until the following morning, before the market opens for trading.
- Your position changes. You are no longer short the option because you were forced to buy it - with no advance notice.
- When trading equity options, the call option you were short is replaced with short stock. Upon assignment, a short put position is replaced with long stock. But, when assigned on a cash-settled option, the option position is canceled and there is no replacement.
- This assignment notice often occurs as a surprise to the option rookie, who not only doesn't understand why anyone would exercise the option before expiration, but also probably doesn't know that early exercise is possible.
|Example 1 - Losses on an OEX Put Spread
Let\'s say you decide to take a bullish position and sell an OEX put spread (which makes money when OEX remains above the strike price of the option sold). Assume OEX is currently 560. (For background reading on spreads, read Option Spread Strategies.)
When you sell a put spread similar to this example, you collect a cash premium, and that cash represents your maximum profit. Under normal circumstances, when you hold this position, either both options expire worthless and you earn $250 profit, or you exit the position by selling the options you own and buying the options you sold. Depending on the cost of exiting the position, you have a profit or loss. This is straightforward.
|Example 2 - The Effects of An Exercise Notice
Let\'s consider a different scenario. Let\'s assume that late one afternoon, about two weeks prior to June expiration, OEX is trading at 500. That\'s not good because there\'s a high probability that both options will be in the money when expiration arrives, forcing you to take the maximum loss. But there\'s hope. About two minutes after the stock market closes for trading (index options continue trading for another 15 minutes), the U.S. Federal Reserve unexpectedly announces an interest rate cut of 50 basis points (0.5%). (To learn about how interest rates influence options, read Managing Interest Rate Risk.)
The announcement takes everyone by surprise. Stocks have stopped trading for the day on the NYSE, but after-hours trading is taking place and stock prices are higher. Stock index futures soar, indicating that the market is expected to open much higher tomorrow. The OEX calls increase in price as everyone wants to buy. Similarly, puts are offered at lower prices. The bid/ask prices for the options change, but the OEX has an official closing price of $540. The index price ignores after-hours trading.
The OEX Jun 540 puts (your short option) was $40 before the news, but now the bid has dropped to $28. No one will sell that option at that price. Why? Anyone who owns the put can exercise it and receive the option\'s intrinsic value (strike price minus OEX price), or $40. (For more insight, see Understanding Option Pricing.)
When you get home from work and hear the news about interest rates, you are elated. What a lucky break for you! If the rally continues and OEX moves above 540, you will earn a profit from this position.
The Next Day …
You eagerly open your computer the following morning. Sure enough, the DJIA futures are 250 points higher. But, when you look at your online brokerage account you notice something unusual. Your OEX position shows that you are long 10 Jun OEX 530 puts, but there is no position in the Jun 540 puts. You don\'t understand, and immediately call your broker.
The customer service rep tells you to look at your transactions for yesterday. You know you didn\'t make any trades, but there it is – right in front of you: You bought 10 Jun OEX 540 puts @ $40.
You carefully explain that there must be some mistake because you didn\'t make the trade. That\'s when the rep tells you that you were assigned an exercise notice that obligated you to repurchase those options at last night\'s intrinsic value. With the OEX closing price of 500, you must pay $40 for each option. The customer service rep tells you he\'s sorry, but nothing can be done. He asks why you failed to exercise your Jun 530 puts when the news was released. But perhaps you didn\'t know you could do that.
Your spread is gone. All you have left is 10 Jun OEX 530 puts. When the market opens and OEX is 515. There\'s no reason to gamble by holding the puts, so you unhappily sell the OEX Jun 530 puts, collecting $15 for each. You thought your maximum loss for the trade was $750 per spread, but you paid $25 to close the spread (pay 40, sell at 15) and thus lost $2,250 per spread ($2,500 to close the position minus the amount you collected for the spread at the beginning, which in this case was $250 per spread), or $22,500 when you account for entire position of ten contracts. Ouch!
Protecting Yourself from Early Exercise
It's too late to do anything in the imaginary scenario above, but now that you understand the problem, there are two good alternatives:
1. Don't sell OEX options.
2. Trade one of the other indexes that are cash-settled, European style.
In these cases, you cannot be assigned an exercise notice prior to expiration and this unhappy event won't ever happen to you. (For further reading, see Vertical Bull and Bear Credit Spreads.)