When Your Options Are Exercised

I received a few emails from readers whose option holdings have 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 are American style, meaning that they can be exercised at any time by the owner. This is opposed 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 and 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. This requires you to deliver the stock equivalent of the option you are short, plus any quarterly dividends that are due.

You get notice of this assignment in an email after the close. You then need to email or call your broker back informing him that you want to exercise your remaining long option position to meet your assigned short position. This should completely close out your position. 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 completely loses the premium on his at-the-money 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 as single penny profit.

Assignments create a risk for option spread owners in a couple of ways. If you don?t check your email every day, you might not be aware that you have been assigned. Alternatively, emails sometimes get lost, or hung up in local servers, 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.

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. You shouldn?t lose much, if any, money in this event, as your long and short options positions perfectly hedge each other. But it could produce some disconcerting communications from your broker. Brokers 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 my email.

The readers I have heard from still had a profit in the positions after an assignment, albeit a smaller one. Consider it a cost of doing business, or a frictional cost. In-the-money options are still a great strategy. But you should be aware of all the potential costs and risks to get the most benefit.

John Thomas