Thursday, March 26, 2009

Trading Lab Recap- Part II Exercise and Assignment

Option Buying:
Call option owner's have the right to buy 100 shares of the underlying
Put option owner's have the right to sell 100 shares of the underlying

When an option owner exercises their option, they are exercising their right to buy or sell the underlying stock.
When an option is exercised the option owner loses all the extrinsic value. Consider the following scenario:

Stock XYZ @ $50
I own a 45 call option currently worth $6 ($5 intrinsic value, $1 extrinsic value)
To exit the trade I could do either of the following:

1. Sell the call to bring in $6
2. Exercise the call, buy stock at $45, then sell stock @ $50, thus bringing in $5

Scenario 2 brings in $1 less due to the loss of the extrinsic value.

Option Selling:
Call option sellers have the obligation to sell 100 shares of the underlying
Put option sellers have the obligation to buy 100 shares of the underlying

Investopedia defines assignment as follows: "When assigned, the option writer has an obligation to complete the requirements of the option contract. If the option was a call (put) option, then the writer would have to sell (buy) the underlying security at the stated strike price."

At expiration all out-of-the-money options expire worthless, all in-the-money options are automatically exercised and assigned.

Just remember, if you own an in-the-money option and ride it to expiration, the option will be exercised resulting in you being long stock (call) or short stock (put)

If you're short an in-the-money option and ride it to expiration, the option will be assigned resulting in you being long the stock (put) or short the stock (call)

American Style options can be exercised early (the majority of stock options)
European Style options can't be exercised early (some index options such as SPX, NDX, RUT)

I know my odds of assignment are higher when:
1. Short option is in-the-money
2. Short option has little to no extrinsic value left ($.25 or less)
3. Stock is getting ready to go ex-dividend

To avoid assignment, we could buyback any in-the-money options when there is little to no extrinsic value remaining.

Let's review how a bear call spread could play out if held to expiration:
95-100 March bear call spread on GS
Short 95 call I have to sell 100 shares of stock @ $95
Long 100 call I can buy 100 shares of stock @ $100

GS is at $97 at expiration:
Short 95 call will be assigned, resulting in 100 short shares @ $95
Long 100 call expires worthless

GS at $105 at expiration:
Short 95 calls get assigned - Short 100 shares @ $95 / Long 100 call is exercised - Long 100 shares @ $100
The result is a wash!

Remember this table for delta hedging:
Positive Delta: Buy stock, Long Calls, Short Puts
Negative Delta: Short Stock, Long Puts, Short Calls

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