A Special Note on Exercised Options

There are only 13 days left to the options expiration on October 18. The Mad Hedge Fund Trader’s model trade portfolio has six positions that are deep in-the-money that expire that day. So, it is important that we tread carefully to get the bull benefit.

I received a few emails from readers whose option holdings have already been exercised against them, and have asked me for advice on how best to proceed. So, here we go.

The options traded on US exchanges and referred to in my Trade Alerts are American style, meaning that they can be exercised at any time by the owner. This is in contrast to European style options, which can only be exercised on the expiration day.

The call option spreads that I have been recommending for the past year are composed of a deep out-of-the-money long strike price plus a short portion at a near money strike price.

When stocks have high dividends, there is a chance that the near money option you are short gets exercised against you by the owner. This requires you to deliver the stock equivalent of the option you are short, plus any quarterly dividends that are due. Don’t worry, because your long position perfectly hedges you against this possibility.

You usually get notice of this assignment in an email after the close. You then need to email or call your broker back immediately informing him that you want to exercise your remaining long option position to meet your assigned short position.

This is a gift, as it means that you can realize the entire maximum theoretical profit of for the position without having to take the risk of running it all the way into expiration. You can either keep the cash, or pile on another sort dated option spread position and make even more money.

This should completely close out your position and leave you with a nice profit. This is not an automatic process and requires action on your part!

Assignments are made on a random basis by an exchange computer, and can happen any day. Exercise means the owner of the option that you are short completely loses all of the premium on his call.

Dividends have to be pretty high to make such a move economic, usually at least over 3% on an annual rate. But these days, markets are so efficient that traders, or their machines, will exercise options for a single penny profit.

Surprise assignments create a risk for option spread owners in a couple of ways. If you don’t check your email every day after the close, you might not be aware that you have been assigned. Alternatively, such emails sometimes get lost, or hung up in local servers or spam filters, which occasionally happens to readers of my own letter.

Then, you are left with the long side deep out-of-the-money call alone, which will have a substantially higher margin requirement. This is equivalent to going outright long the stock in large size.

This is a totally unhedged position now, and suddenly, you are playing a totally different game. If the stock then rises, you could be in for a windfall profit. But if it falls, you could take a big hit. Better to completely avoid this situation at all cost and not take the chance. You are probably not set up to do this type of trading.

If you don’t have the cash in your account to cover this, you could get a margin call. If you ignore this call as well, your broker will close out your position at market without your permission.

It could produce some disconcerting communications from your broker. They generally hate issuing margin calls, and could well close your account if it is too small to bother with, as they create regulatory issues.

It order to get belt and braces coverage on this issue, it is best to call your brokers and find out exactly what their assignment policies and procedures are. Believe it or not, some are still in the Stone Age, and have yet to automate the assignment process or give notice by email. An ounce of prevention could be worth a pound of cure here.

Consider all this a cost of doing business, or a frictional execution cost. In-the-money options are still a great strategy. But you should be aware of all the ins and outs to get the most benefit.

John Thomas