Lessons from the Pros


Your Assignment for Today…

In options, “assignment” is what happens to someone who has sold short an option, when that option is exercised by the other party. Let’s look at the ramifications of this event.
Let’s say that on December 18, you owned 100 shares of stock in American Airlines (AAL), with a current value of $50 per share, a post-crash high. There are call options at the $52.50 strike on that stock that expire in a month, which are currently trading at $1.68 per share. You note that $52.50 is above the recent highs. You think that it could take more than a month for AAL to reach $52.50, and that in any case you would be happy to sell it at that price. So you sell a January $52.50 call.

Free Workshop

By selling the call option, you have obligated yourself to turn over the stock and accept $52.50 per share for it, if that is demanded by the option buyer (the option is exercised). In that event, your call option will be assigned, meaning you must turn over the stock.

If that happens your total proceeds per share would be that $52.50 strike price, plus the $1.68 you received for the call, or $54.18 per share. This would be a return of $4.18 on $50, or 8.36% in a matter of 29 days; over a 100% annualized rate of return.

If AAL does not exceed $52.50 a month from now, the option will not be assigned. Option buyers are not required to exercise their options. No option owner will demand that you sell the stock to them at $52.50, unless the stock is then selling for more than that. If not assigned, you keep the stock. You also get to keep the $1.68 option premium.

You are quite happy with this trade. Then AAL does in fact shoot up. In a couple of weeks it passes $52.50, then $55, then $58. At that point the $52.50 call you sold for $1.68 is quoted at $ 5.55.

Is there anything you can or should do? You know that assignment is now virtually assured. Because of the call you sold, you are obligated to accept $52.50 for the stock regardless of how high its price actually goes. If you do nothing, the stock will be taken away from you in two weeks, and you will receive your $52.50 payment.

There is now no way to make any more profit on this trade than the $4.18 maximum you locked yourself into. But you can at least take action to re-deploy your investment early, rather than letting it be dead money for another two weeks.

At the current price of $5.55, the $52.50 call option contains almost no time value. With AAL at $58, the $52.50 call, if exercised, would offer the option holder a discount to market value of $58.00 – $52.50, or $5.50. This amount is called the option’s intrinsic value. Any excess of the option’s market value over this intrinsic value is referred to as extrinsic value, or time value. That is now just five cents ($.5.55 – $5.50).

It is normal for options that are far in the money, as this one is, to have little or no time value. The reason is that in the remaining time, there is almost no way that the probability of this option’s being assigned will change. That probability is about 100% and will remain so in the limited time remaining.

Once that point is reached, it is better to “assign yourself” than to wait for it to happen to you. You would do this by paying the $5.55 to buy back the call option, and then selling the stock at $58.00. Your net current positive cash flow will thus be $58.00 – $5.55, or $52.45. This is just $.05 less than the $52.50 that you will receive two weeks from now if you let yourself be assigned. With your money back in your hand, you can now re-invest it elsewhere, and almost certainly make up for that $.05 and more.

This is a good thing! You already decided that you would be happy with a $4.18 maximum return on this investment if it happened in a month. It has now happened in two weeks, which is even better. The fact that you had to sell a $58.00 stock for $54.18 is no cause for regret. That was an exceedingly unlikely event that no one could have reasonably predicted. Your goal now is to find other opportunities, and to congratulate yourself on picking a winner.

So now the last question – at what point should you decide to pre-emptively assign yourself?

The answer is: at the point where the stock has risen high enough that the options have little to no time value. You need to check the stock and option prices every few days at least. If the stock is above the option strike price, the option’s time value is a simple calculation: time value = option price – (current stock price  – option strike price). When that calculation yields a value of just a few cents, there is nothing more to be gained by waiting. Until then, you can leave the position in place, as it is still making money as long as the option’s time value declines.

Having to decide when to take a profit early is a high-class problem to have. Here’s hoping that it is a decision that you will face often.

For comments or questions on this article, contact us at help@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.