Monday, March 29, 2010

Mail Time: Call Spreads and Assignment

Hey Tyler. I purchased a July 240-250 call spread (bull call spread) for $4.80 on March 9th when PCLN was right around 240. After PCLN rallied to $262, the short 250 call was $12 in-the-money. Rather than waiting closer to expiration to realize more profit, we decided to exit early to avoid being assigned. Even though PCLN rallied $12 above our call spread, we only made about $180. Could you give me your insight on what we did wrong or missed in the trade? Also, with so much time value left in the trade, what is your opinion on early assignment?

Thanks, Kevin-

For the call spread to reach maximum profit potential, it must lose all of its extrinsic (time) value. For this to occur 4 months prior to expiration (as we stand right now), the calls have to move deep enough ITM to lose all of their extrinsic value. When an ITM option loses all its extrinsic value and is trading at its intrinsic value, we say it’s trading “at parity”. You can consult a risk graph to assess how high PCLN would have to move before expiration for you to capture the majority of your profit. Given that you used July options which still have 4 months to expiry, PCLN would probably have to move up toward 290 for the call spread to be anywhere close to its max profit at this stage in the game.

The other scenario which would cause the call spread to lose its extrinsic value is time decay. As a slightly ITM call spread approaches expiration it will increase in value bit by bit as extrinsic value whittles away. This is due primarily to the fact that the short call option possesses more extrinsic value than the long call option making the spread positive theta. When choosing to use call spreads, one must be aware that they perform more like position trades and take time to mature. For the impatient not wanting or willing to wait too long, you may consider using shorter term options. Though this doesn’t provide as much time for the stock to move above the higher strike of the spread, it does produce quicker results if you are indeed right.

As far as early assignment goes, you would not have been assigned this early in the game and even if you were it’s to your benefit, not detriment. Keep in mind when an option owner exercises, they lose any remaining extrinsic value in the option. Thus, if there was still $4 or $5 of extrinsic value in the 250 call option, they would be better off selling it as opposed to exercising. For illustrative purposes, let’s say you were assigned and obligated to sell 100 shares of stock at $250. Again, this isn’t necessarily a bad thing. You still own the 240 call and thus have the right to buy 100 shares at $240. If you exercised that right, bought 100 shares at $240 and sold them at $250, you would net $10. Since you entered the trade at $4.80, you would essentially be capturing your $5.20 of profit. And the beauty of it is you realized it in March instead of having to wait until July.

So did you make any mistakes? The answer really depends on what you were trying to achieve. If you were satisfied with the profit and had planned on exiting after a decent sized gain, then I’d say you did ok. On the other hand, if you were shaken out early because of fears of early assignment, I’d say perhaps you did make a mistake. As outlined, those fears are unfounded.

For related posts, readers can check out:
Call vs. Put Spreads
All that Glitters is GLD


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Mark said...

great answer Tyler. I'll never get over how afraid people are afraid of assignment.

Tyler Craig said...

Thanks Mark. My bet is it's just fear of the unknown. All it takes is running the numbers to show early assignment can be a benefit.

MarkWolfinger said...

The big mistake made by this trader is trading options with no understanding of what has to happen to earn a profit from the trade.

Sure the stock rallied, but it was not a sufficient rally. The bid/ask differential is probably a big reason for the small profit.

Agree that being assigned should be a delight, not a problem, but there are those who trade $250 stocks with insufficient cash to meet a margin call. [Yes, long an ITM call and short shock should have a margin requirement of ZERO, but some brokers have absurd requirements].

Tyler Craig said...

Good points Mark-