Q&A
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.
To Close or Not to Close
I have a put credit spread on a stock where the sold leg is out-of-the-money and the bought leg is deep in-the-money. I have already bought back the sold leg and the bought leg is left to be exercised. Should I let the buy leg be exercised and reap the profit or should I close it out before expiration?
If you have a put credit spread, the trade was entered by selling a put and also buying a put with a lower strike price. Basically, selling the put credit spread is the same as selling a put, but another put with a lower strike is purchased as a hedge. Simply selling puts would expose the investor to more risk than trading the credit spread.
The “credit” from the put credit spread comes from the fact that the option with the higher strike price has more premium than the put with a lower strike price. Puts with higher strike prices are worth more than puts with lower strike prices.
For example, one stock I like to trade was recently at $83.40 per share. If it falls to $75, I will consider it a screaming Buy! Since I’m willing to buy the stock at $75, I might write or sell a put with a $75 strike price. Looking at the quotes, the July 75 put is recently going for $10 per contract, so I can pocket $1,000 for selling one put ($10 x 100). If the stock sinks below $75 by the July option expiration, I am going to face assignment, and if so, I will pay $7,500 to take ownership of 100 shares (have 100 shares “put” to me). Each short put obligates me to buy 100 shares at the strike price.
If the stock falls to $50, for example, I could suffer a significant loss because while I am assigned at $75, I can only sell for the current market price of $50. If I am assigned 100 shares at $75 and sell at $50, the net result is a loss of $2,500 minus the premium received for selling the call (1,000), for a loss of $1,500. The more the stock falls, the greater the risk from holding short puts.
To mitigate some of that risk, I might sell the July 75 put for $10 and also buy the July 60 put for $5. My credit is now only $5.00 ($10 for selling the 75 put minus $5 for buying the 60 put), but my risk is substantially less. If the stock tanks, I have the right to sell it at $60 per share, no matter what happens. So the put credit spread is a lower risk-reward strategy compared to simply selling puts.
To answer the specifics of your question, if you opened a credit spread, it would not be possible for the sold or short leg to be out-of-the-money while the bought leg is deep-in-the-money. If the stock price falls, the opposite would happen. If my stock were to fall to $70, the short side (July 75 put) of my credit spread is in-the-money and the option that I bought as a hedge (July 60 put) is still $10 out-of-the-money.
In this situation, the best course of action will depend on what you wanted to accomplish in entering the spread. If your goal was simply to collect premium and not take ownership of the stock, it might make sense to admit that the trade went against you and close it out. However, if you wanted to buy the stock at the strike price of the put, you can wait to get assigned and take ownership of the stock. Or it might make sense to first salvage any value remaining in the spread by closing it and then buy the stock in the market instead.
The best course of action will depend on how much time premium is left in the spread and brokerage commissions. If you aren’t sure in a specific situation, discuss it with your brokerage firm.
What Happens If...
What happens if you do a vertical spread and the person to whom you sold the call or put decides to exercise their option? Wouldn’t that ruin your trade if you wanted to hold the spread longer?
There are two types of vertical spreads: the debit spread and the credit spread. In the previous question & answer, we looked at the put credit spread. If, for example, the put seller exercises the option and the short put is assigned to me at expiration, I will be taken out of the spread because the short side of the spread becomes a position in shares. I am then left with a position in shares, plus a put. My position is not necessarily “ruined”; it has simply been modified from one strategy to another. It’s still a hedged trade, but I need to decide whether to keep it, close it, or make some other adjustment.
Keep in mind: the odds of assignment increase as the option expiration approaches. If the short side of the spread is in-the-money with little time value remaining, the strategist should be prepared for assignment. In the credit spread, the trade is probably not working out as planned if my short option is at risk of assignment. As expiration approaches and the chances of assignment increase, it might make sense to close out the spread rather than face the chance of assignment.
In a debit spread, the strategist is long a put (or call) and short a put with a lower (or higher) strike price. If I create a vertical spread by purchasing the July 75 call and selling the July 90 call, my short call will not be assigned unless my long call is also deep in-the-money. Therefore, I make a good profit if assigned because if the stock is called at $90 per share, I can exercise my $75 strike call to buy it at $75. Therefore, I buy at $75 and sell at $90, which is my maximum profit potential for this spread.