Exercise of options

Hi All,
Usually I buy at the money or slightly out of the money options as a proxy for the underlying. However, I'm moving on to using spreads for hedging aswell and this has raised a question that I'm sure someone here can clarify for me. I'm not exactly trying to uproot any trees here but want to fully understand the pros and cons of what I do as a I go forward...

I currently have an active bear spread on WMT (SELL DEC05 CALL 42.5, BUY DEC05 CALL 47.5). I am expecting the price to go lower and it is. However, I've been considering the process of exercise should the stock bounce and go higher.i.e. if I get assigned and have to cough up the required number of WMT shares. I will exercise my own option in response but am not sure about how the timing of all this would work and whether I'd get caught short. I never exercise my options buys and so have never been through the process.

So, is exercising an option in order to meet an assignment a valid approach?

Thx,
D
p.s. My broker is IB.

I've been exercised on a spread before. Since I didn't have the shares to cover it my broker automatically exercised my long option. It really wasn't a big deal. I think I had to pay an exercise fee though.

So, is exercising an option in order to meet an assignment a valid approach?

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Hopefully an option practitioner will come a long and answer for you with more authority than I as I do not exercise options often either and do nott sell them, but my guess is no to your question, The problem is that you will not know immediately that you have been assigned, The regulations state that traders assigned must be informed in a 'timely manner" but that may be subject to some interpretation, suffice to say that you may be informed, at the earliest, tomorrow morning that you have been assigned the exercised calls, which were exercised at 11am today. So where the stock may be trading tomorrow morning compared to where it was trading this morning may have some serious impact.

fundjunkie said:

I will exercise my own option in response but am not sure about how the timing of all this would work and whether I'd get caught short

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The timing is such that you will not learn of the exercise until the next business day following exercise so yes, you could be caught short (or long) at least here in the UK. Obviously any underlying price move could also work in your favour and in any event, where you have a long option as cover your liability will never exceed the difference between the two strikes.

fundjunkie said:

So, is exercising an option in order to meet an assignment a valid approach?

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No. You shouldn’t exercise an option where there is any time value remaining as you’d be better off just selling the option in the market.

It is very rare to be assigned, unless there is a dividend in play.

You can see assignment figures here;
http://www.liffe.com/reports/eod/eod?item=Daily

Look at;
London Equity Options A-B
London Equity Options C-H
London Equity Options I-P
London Equity Options Q-Z

fundjunkie said:

Hi All,
Usually I buy at the money or slightly out of the money options as a proxy for the underlying. However, I'm moving on to using spreads for hedging aswell and this has raised a question that I'm sure someone here can clarify for me. I'm not exactly trying to uproot any trees here but want to fully understand the pros and cons of what I do as a I go forward...

I currently have an active bear spread on WMT (SELL DEC05 CALL 42.5, BUY DEC05 CALL 47.5). I am expecting the price to go lower and it is. However, I've been considering the process of exercise should the stock bounce and go higher.i.e. if I get assigned and have to cough up the required number of WMT shares. I will exercise my own option in response but am not sure about how the timing of all this would work and whether I'd get caught short. I never exercise my options buys and so have never been through the process.

So, is exercising an option in order to meet an assignment a valid approach?

Thx,
D
p.s. My broker is IB.

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hi,

you can easily tell if your short Option will be exercised :-
a) Has it got any time value, if yes, then no chance of early assignment (except for a dividend, see below).
b) If it has no time value. Does the Put of the same strike have any value at the bid (or any chance of being hit if you go on the offer?) - if the Put has value then the person long the Call should sell the Put rather than exercise the Call.
c) No time value in the Call or the Put - get ready for the assignment !!

If a stock is about to go XD then be very ready - if the dividend that could be received by exercising is greater than the time valu in the Call and the value of the corresponding Put combined then an early assignment is very likely.

You should only contemplate exercising your Long Call part of the spread if the above criteria also apply to you (in reverse) - never just automatically exercise to close your equity position it could be a lot cheaper to get your broker to just close the bargain in the market.


rgds

Profitaker said:

No. You shouldn’t exercise an option where there is any time value remaining as you’d be better off just selling the option in the market.

It is very rare to be assigned, unless there is a dividend in play.

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I predominantly buy in the money options to avoid "time" muddying the waters. If I buy out of the money it's purely speculative (more than normal).

Thanks for the assignment stat link. I'll check it out. By the way, all of my dealings are in the US markets. I feel it's a more true and open market to allcomers even though it can increase my costs as a result.

apples10 said:

hi,
b) If it has no time value. Does the Put of the same strike have any value at the bid (or any chance of being hit if you go on the offer?) - if the Put has value then the person long the Call should sell the Put rather than exercise the Call.
c) No time value in the Call or the Put - get ready for the assignment !!

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Why and when I get called is of less interest to me than when and how I can/should react if called. I "think" I'll have time to exercise my own call or put, if it makes sense to do so. However, I'm not sure how the sequence of events from assignment to delivery works. Of course, if I get assigned at expiry time then the decision is made for me...


Thx,
D

Fundjunkie,

I'm curious as to how you trade options without '"time" muddying the waters'. Always regarded time as pretty fundamental to any options strategy myself.

Gareth

garethb said:

Fundjunkie,

I'm curious as to how you trade options without '"time" muddying the waters'. Always regarded time as pretty fundamental to any options strategy myself.

Gareth

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I prefer to buy with as little time premium as possible. I thought you'd have realised that rather than infering that I was refering to a holding period of zero. Now that would be rather silly...

Anyway, do you have anything to add regarding the question central to this thread?

Thx,
D

Sorry fj no offence meant but you can probably see my confusion given your very first sentence on the thread implying buying options with considerable time value.

If you want advice pertaining to the subject of the thread I suggest you ensure you understand apples10's excellent post explaining why it is rarely the correct decision to excercise an option until very close to expiry, and the impact of dividends on the decision.

The main complication arrises when stock is very near the strike price on the final day. You do not know whether you will be assigned or not. A lot then depends on whether you have the margin status to ride out the stock position for a while. There have been some sorry tales of people ending up with a position which their broker then closes in the market first thing next business day when the stock gaps against them. This can cause considerable losses.

You need to talk to your broker and understand under what conditions he will auto excercise your longs and what he will do if you are assigned. How he will treat the resulting position for margin if you have a combination of stock and option. As apples10 explains it is often not the correct decision simply to excercise the other side of your spread. I do not use IB myself but they do have a bit of a reputation for being fairly strict on margin rules (hardly surprising given their general position on discount fees etc.)

Best Regards,

Gareth

garethb said:

The main complication arrises when stock is very near the strike price on the final day. You do not know whether you will be assigned or not.Gareth

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Correct, and otherwise known as "Pin" risk.

garethb said:

You need to talk to your broker and understand under what conditions he will auto excercise your longs and what he will do if you are assigned. How he will treat the resulting position for margin if you have a combination of stock and option. As apples10 explains it is often not the correct decision simply to excercise the other side of your spread. I do not use IB myself but they do have a bit of a reputation for being fairly strict on margin rules (hardly surprising given their general position on discount fees etc.)

Best Regards,

Gareth

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Yes, while this threads been going I've started talking with my broker to clarify the process. It became clear to me that the process of meeting your assignments isn't 100% standard.

Anyway, thanks for the input. There's been a number of very helpful replies and insights.

Thx,
D