WHAT’S REALLY IN THE BOX?
You know that an option gives you the right
but not the obligation to buy or sell stock at a
set price. But did you know that the price of
an option has two components—intrinsic*
and extrinsic* In the case of exercising an
in-the-money (ITM) long call, you buy the
stock at the strike price, which is lower than
its prevailing price. In the case of a long put
that isn’t being used as a hedge for a long
stock position, you short the stock for a price
higher than its prevailing price. You’ll only
capture an (ITM) option’s intrinsic value
if you sell the stock (after exercising a long
call) or buy the stock (after exercising a long
put) immediately upon exercise. If you don’t,
you take on all of the risks associated with
holding a long or short stock position. So,
the question of whether a short option might
be assigned depends on if there’s some perceived benefit to another trader exercising a
long option that you happen to be short.
Fortunately, there’s a method to the
madness.
SYNTHETICS: BEHIND THE CURTAIN
When you’re short an option, you need to
put yourself in the shoes of the person who’s
long that option. Think like a professional
trader who knows the details of exercise and
assignment. If you’re short an option that’s
ITM, the other trader who’s long the option
might exercise it. If it’s out of the money
(O TM), it’s less likely. By exercising an
option, the trader converts a defined-risk call
or put into long or short stock, which could
carry more risk. So, the other trader will
likely want to hedge that stock by creating a
synthetic. In the options world, synthetics
are constructed from a short list of elements:
calls, puts, and stock.
Say a trader exercises a long call and takes
delivery of long stock. Let’s say he then buys
a put at the same strike as the call he just
exercised to create a synthetic long call*.
If a trader exercises a long put, he creates a
short position, i.e., deliver stock you don’t
own. He’ll likely buy a call at the same strike
as the long put he just exercised to create a
synthetic long put*. If you want to see if an
ITM short option might be assigned, you
have to look at the corresponding O TM
option at the same strike (Figure 1).
Because the synthetic option contains
long or short stock, capital requirements for
the synthetic position could be considerably
greater than those for the long call or put
option.
Let’s look at the cash flows around exercise and synthetics. If you exercise a long
call, you have to pay for the stock with cash
from your account. Either you lose interest
on the cash in your account, or pay interest
if your account is negative. For example, if
you exercise a long 30-strike call with 10
days to expiration and the interest rate is 2%,
the interest would be ($30 x 0.02 x 10)/365 =
$0.0164. Note that the interest isn’t calculated on the $3,000 the strike represents. That’s
because you want that interest number to be
in terms of the option’s price.
FIGURE 1: What if you get assigned? Check out the value of an OTM put and ITM
call of the same strike price. If you’re trying to see whether your short ITM call might
be assigned, compare the price of the OTM put to the expected dividend.
Source: TD Ameritrade. For illustrative purposes only.
Fortune cookie says, “Pay close attention.”
Maybe your hairdresser was drunk, but you ignore the results. Or, half asleep, you buy a case of tube
socks on TV even though shipping fees cost more than the product. Or you bravely concoct Alfredo
sauce with no recipe (’cause your mom could). In the long run, ignorance can be tricky. Like getting
assigned on a short option. If you’ve ever held a short option position through a covered call*, or
iron condor, you know there’s a risk of early assignment—i.e., you could be forced to buy or sell stock
when the short option you sold is exercised. Instead of guessing when you might get assigned
on a short option position, let’s explore the science behind “early exercise” so you can potentially
get ahead of the unexpected. (And learn to put down the remote.)
