Lessons from the Pros


Options Mailbag

Over the last few months, I’ve gotten quite a few letters with questions about the options articles. Today is a good day to follow up on some of those questions, and make some clarifications.

Risk of Assignment:

First, Mike B. writes about the risk of assignment when selling puts.  He says:

Here is my issue: if I am writing a put  or a call, I would hope for the option to expire worthless; however, I would be running a great risk, if it would not expire worthless! What and how do I prevent the risk of the obligation to have the position put to me? In case of an example for explanation, I would prefer the scenario of writing a put option w/o risking to be assigned!

Good question, Mike, and here’s my response:

You are correct that when writing options, there is a risk of assignment. Let’s talk about puts.

First, there is the risk that the put ends up in the money at expiration, in which case it will definitely be assigned. We guard against this risk by making sure to cover the short puts on or before expiration day if the underlying price trades through the strike price. And to guard against an event that happens after hours on expiration Friday but before option settlement on Saturday, we should also buy back the short puts on expiration day even if they are far OTM. They will cost a penny or two to buy back in that case.

 Second, there is the risk that a short put will be assigned before expiration. For puts, that risk becomes real in only one particular situation: the put is so far in the money that it has virtually no time value in it (that is, it is nearing a delta of -1.0, which also means that its price consists almost entirely of intrinsic value). It is sometimes in the interest of large traders to exercise such puts. As retail traders, we should generally have been out of these short puts long before they reached a position of being that far ITM.

 Puts that are not quite far ITM are almost never exercised early – if they are, a big mistake has been made by the put owner. 

 Remember for your short put to get assigned, some put buyer had to decide to exercise early. If his put had any time value in it, he is surrendering that time value (throwing away money, which ends up in your pocket) by exercising the put. He could always have made more money in that situation by simply selling the put (and the stock, if he owned the stock) on the open market, which would have no effect on you. Early exercise of puts which have any time value is always a mistake. There is a single esoteric exception to that last sentence, which we would virtually never encounter: In times of very high interest rates, it can occasionally make sense for a large trader to exercise a put for interest, if the exerciser can earn interest on cash generated from short sales, and that interest income exceeds the time value given up. We won’t see that any time soon.

So the answer boils down to this:

  1.      If you are short puts, don’t worry about their being exercised as long as they have any time value in them.
  2.      If they go so far ITM that they have no time value, your position has probably gone so far against you that you should have been out long ago – exit or make an adjustment.
  3.      When short options are OTM on expiration day, buy them back for a few pennies to avoid any chance of assignment.

 If these safeguards are not enough to make us comfortable writing puts, then we might consider a variation on the short puts that positively removes the potential unlimited risk.

 Even if we do take the safeguard of covering the puts on expiration day and if the price trades through the put strike before that, we are left with one additional risk – that of a sudden gap opening far below your short put strike price. 

 If you do not want to accept assignment in that case, you can buy insurance against it by using a bull put spread instead of just writing a put. By adding a long put (at a lower strike price) to your short put, you create a position where, in effect, if the stock is put to you, you can put it right back, although at a lower price. You are therefore assured that your maximum cost to exit the position can never exceed the difference between the two strike prices.  That difference, minus the net credit you received for the spread, is your maximum loss. 

 That insurance comes at a cost, of course – the price of the long “insurance” put. But it does turn a position with unlimited downside risk into one with known and limited risk.

 Variations on Double Vertical Spreads

Lynn B writes about my recent example of a double vertical spread on GLD. You can review that article here. With GLD around $135 at the time, I sold a July 120/125 OTM bull put spread for an $80 credit, and simultaneously bought a July 150/155 OTM bull call debit spread at $41 debit; for a net credit of $39. The $39 credit would be mine if GLD ended up anywhere between the short strikes (125 to 150) until July. If GLD took off, and ended up above 150, then my profit would be increased by $1 for every dollar that GLD exceeded the $150 strike; up to $155, where my profit would peak out at $539.

Here’s Lynn’s question:

I use a similar spread, but instead I replace the bull call debit spread with a bull put credit spread. Are there any advantages to doing it your way?

Lynn, you are correct that a bull vertical spread with puts is an almost exact equivalent to a bull vertical with calls, when each is done at the same strike prices. So in my Double Vertical example, I could have used a bull put credit spread at the top end, buying a 150 put and selling a 155 put. In that case, the maximum gain and maximum loss on the two versions of the 150/155 bull spread would have been about identical.  So the whole position’s max profit and loss would also have been about the same.

The main reasons to choose between the credit form of the vertical and the debit form are practical ones, not theoretical:

1.     Some people have authorization to do debit spreads but not credit spreads

2.     In the credit spread form, it’s possible everything expires worthless, eliminating any cost to exit the position.

3.     Capital requirements on the credit spread are often larger. While the debit spread can only lose the net debit, which may be very small, the Credit spread can lose the whole difference between the strikes, minus the original credit, and this much margin must be put up.

Anyway, I like that kind of educated question. Thanks for the questions, folks, and keep them coming.

For comments or questions about this article, contact me at rallen@tradingacademy.com.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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