Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. |
Tom Gentile of Optionetics |
EARLY ASSIGNMENT ON CREDIT SPREADS
After a credit spread on equities is executed, is there a risk of early assignment on the short leg if extrinsic value goes below $0.20? Before execution, if the short leg of a credit spread has an extrinsic value of $0.20 or less, will it ever be executed? I know there is no early assignment on calls/puts on European-style indexes. I'd appreciate your advice. --Paul
You are correct that options with the European-style settlement feature do not carry any early-assignment risk because exercise and assignment can only happen at expiration. Most (but not all) index options settle European-style and can only be exercised at expiration.
Stock options settle American-style and, as a result, exercise and assignment can happen any time prior to expiration. But it isn't likely that an option with time value will be exercised, because the option owner would lose or sacrifice that time value if they exercise the contract. They would be leaving money on the table. When time value remains, it is usually better to sell the option to close the position rather than exercise it.
As a rule, if expiration approaches and the time value of the option is 25 cents or less, the option writer should be prepared for the possibility of assignment. Time value or "extrinsic value" is computed as:
It doesn't matter whether the short option is part of a spread; the odds of early assignment are the same. The option owner, or the party long the options, doesn't care whether you hold the short position naked or as part of a spread. They will exercise the option regardless.Call time value = (Call strike price+ Call option price) - Stock pricePut time value = (Stock price- Put option price) - Stock price
However, once there is little time value, the option seller or writer might face assignment. In the case of a put, assignment involves buying the stock at the strike price of the put. For a call, the option writer must be willing to sell the stock at the strike price of the option. If assignment is an unwelcome outcome, the strategist might want to consider closing out the position or rolling it forward to another expiration month or strike price where more time value remains.
In addition, even if the short option has little time value, the order to buy or sell the contract will be executed by the broker. The trader can always sell an in-the-money contract, even if it has little or no extrinsic value. The order will be executed.
Sometimes a strategist might sell an option with the expectations of assignment. For instance, an option writer might sell puts on XYZ rather than buy shares. In that case, the strategist is willing to buy the stock at a specific price, even if the put has very little time value remaining. Rather than buy XYZ for $49.95, for example, the strategist might sell the XYZ March 50 puts for 15 cents a contract, face the risk of assignment, and then buy XYZ for $50 a share. If assigned, they would get shares for $49.85 (strike price minus the premium received for selling the puts) rather than the current market price of $49.95. If not, the puts expire worthless and the option writer can keep the premium.
LEGGING
What does it mean to "leg" into a trade?
A leg is a term used in options trading that describes one part of a more advanced trade or complex position. For example, a vertical spread consists of two legs -- a long option and a short option. Often, both legs of the trade are established together. For example, a strategist might create a bull call spread by purchasing a call option and selling a call option with a higher strike price. When placing the order, the strategist can specify how much they are willing to pay for the spread. However, the strategist can also leg into the spread by purchasing the long call and, once the order is executed, selling the call option with the higher strike price.
NEW MARGIN RULES
I understand there will be some new rules on margin on stocks and options. What's happening and when?
The Securities and Exchange Commission (SEC) approved the new rules in December and the changes go into effect on April 2, 2007. The rules will drastically change the margin requirements for some investors. Basically, the changes are designed to consider the risk of stocks and options based on the total position in one underlying security rather than using a traditional strategy-based approach.
For example, today, the margin requirement for a protective put (long stock/long put) is 50% for the stock and 100% for the put. However, the risk of the protective put is limited to the stock price at the time of purchase plus the cost of the put minus the strike price of the put. Therefore, the margin requirements are often much higher than the actual risk of the trade. The new margin rules will lower the margin requirement to reflect the true risk of the position. The Chicago Board Options Exchange (CBOE) offers the before and after example of a protective put:
PositionLong 500 Ibm shares @ $91.25Long 5 Puts Ibm April 90 @ $2.50 a contactStrategy-based margin (50% for stock and 100% for put): $24,062.50Portfolio margin (Stock price minus strike plus put price x 500): $1,875
Not all brokerage firms will offer portfolio margin accounts. Some
take a wait-and-see approach, while others do not have the risk culture
to offer investors the added leverage. In addition, the brokers that provide
the new margin calculations will offer it only to qualified investors,
or those with a certain level of experience and minimum account equity.
Originally published in the March 2007 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2007, Technical Analysis, Inc.
Return to March 2007 Contents