need help please with vertical spread

[drcha]

I posted this in the newbies forum, but did not get any responses. Can someone please help a newbie?

I'm reading about put credit spreads. I have the same question, both before expiration and at expiration.

Before expiration: Suppose that I sell a one-month put spread a couple of strikes below the current price, hoping to keep the premium. I sell it as a vertical spread, using a single trade. Then if I want to keep from losing the difference between the strikes, I should set up a conditional order to reverse the position if the stock approaches the short strike. But suppose I am too lazy, or I forget to do this, or suppose I actually do set a stop order but the stock is dropping like a rock and my stop order cannot not be executed quickly enough. Now the short leg is in the money, and the buyer exercises the short leg before expiration. The long leg is still out of the money. Also suppose that my cash position will cover the strike difference, but will not cover the stock price. Will my broker put the stock to me, using margin since I don't have the cash to cover it, or will he exercise the long call that is out of the money?

At expiration: Same situation, I am between the legs at expiration, so I am assigned the stock. Will the long out of the money option be exercised or will I buy the stock?

Thanks for your help!
Mary

 

[dewitte]

Rule of thumb: your broker will never exercise without an explicit order from you.

In both your cases the stock will be put to you and your broker will immediately sell at market. You end up with just your long put (assuming you mean "put", not "call") or, if it expired, with nothing.

Should the stock drop way below even the long strike then your put's value should increase such that it will offset the stock loss. Broker can then *sell* your put to balance your account but will not *exercise* it.

At expiration the ITM put of course will be be auto-exercised.

This, at least, is my experience.

 

[Profitaker]

drcha

Just a short note to add to dewitte's reply;

Be very careful to make the distinction between exercise and early exercise.

 

[maxxam80]

Hi,

The max profit for credit spreads is the difference in strikes minus the credit received right?

However assuming you could always reverse the position before it reached the strike price of the sold option will you always make a profit, due to time decay (ignoring Vega etc), by just buying back the sold option for a cheaper price?

 

[garethb]

Hi,

The max profit for credit spreads is the difference in strikes minus the credit received right?

However assuming you could always reverse the position before it reached the strike price of the sold option will you always make a profit, due to time decay (ignoring Vega etc), by just buying back the sold option for a cheaper price?

The maximum profit of a credit spread is the credit received and occurs when both legs expire worthless.

The Maximum loss is the difference in strikes minus the credit received and occurs when both legs are ITM at expiry.

If you buy back the sold option you may make a profit on that side due to time decay or a move in the underlying but be holding on to a loss making long side the value of which will continue to suffer time decay losing you further money.

Taking as an example a bullish position of a credit put spread. Suppose you have sold a $35 put and bought a $30 put when the price of the underlyling is $40. If the price of the underlying moves down you will be making a loss. Buying back the sold leg (for example when the stock is at $36) will not get rid of that loss. Depending on how long you have held and time to expiry etc. you could make a profit or a loss on that leg but you will probably be down overall on the position unless you are now much closer to expiry, and it will leave you exposed to a long put (transfering a bullish position into a bearish one). If the underlying continues to move down fast enough then you may make enough profit on that to cover your loss, if the underlying stagnates or moves back up you will lose more.

Sorry this is all rather wooly and qualatitive but I hope it makes sense