Tag Archives | early exercise

Trading traps for the unwary

Hi Mark,

I’ve read a few books on options, including one of your books, The Short Book on Options, and I’ve written a few cash-secured puts and covered calls.

Recently, I’ve read of a few cases of new traders blowing up their account due to practical details of the mechanics of trading (described below) and I was wondering if you would recommend any books, education, etc. on these mechanics. For instance, what to do if long puts are automatically assigned upon expiration, or if short legs are assigned in spreads, as well as simpler topics such as bid/ask spreads, order types, conditional orders, orders I should place in advance in case I temporarily go into a coma through expiration, the Pattern Day Trader classification, the same-day substitution rule, Regulation T, etc.

Basically, I’m somewhat shocked that one can even get access to a brokerage account without knowing Regulation T, PDT [Pattern day trader], etc. The stories below scare the living daylights out of me — I wonder what these traders were supposed to have read to understand/avoid those problem in the first place. It really seems like trading was designed for people who have a Series 7 broker’s license and know all these nuances.

Thanks,

Tristan

***

Tristan,

Thank you. These are very important situations, and a thorough discussion can help many traders avoid a nasty situation. And the truth is that these situations arise because we seldom know what we don’t know. We don’t know what questions must be asked, nor are we aware of potential problems. No one warns us.

However, some situations are 100% the fault of the trader. We are responsible for knowing what an option is before trading. We are responsible for understanding risk before we sell naked options. However, we just have no way of knowing when something we do has repercussions that are far from obvious. I don’t blame you for being frightened.

No books necessary

Here is all the education required for the situations described (I am not belittling you, or the poor folks who were hurt – but the truth is that far too many people trade options without following this advice). And I’ve never seen any books on these topics.

1. Know what you are trading. Never take a position if you do not have 100% confidence that you know the rules of trading options.

2. Never trade any options without knowing whether the stock pays a dividend, how much it is, and when it goes ex-dividend.

3. Know the difference between American and European style options.

***

I’m afraid my trade was fairly simple as I used options quite sparingly over the past few years, and have apparently never known the real hidden danger of options. I just bought straight puts.

On March 20th, I was having a pretty good day and thought that I would take a long shot on CME falling. I put in an order for 100 puts strike 230 at .10 and they filled for $1,000. (Right not the obligation.) In the last seconds of the day the shares plunged and ended at 228.62 putting me in the money $1.38/share…but with no time to sell.

I’d never had this happen before. I looked it up and read the statement please have sufficient liquidity or shares in your account. I had neither, so I called the broker to see how I could get the difference. The first lady said they would auto-exercise. I asked if I would need $2.3 M in the account and would I receive the difference (like an index option) [MDW: He is referring to European style options where the option owner gets the intrinsic value in cash – with no shares changing hands] and she responded they would auto exercise after talking with her manager.

I was unsure, so called back. The gentlemen said he thought I did need the $2.3M or the shares, and they wouldn’t extend it on an account with $32K in it (Sensible enough) but was not sure. He suggested I wait until Monday and call the options desk.

On Monday, the stock gapped up pre-market. My account sold at 230 and bought back at 235-236, losing all my money and then some. I guess this is normal. My question is, what are the limits of margin. If $1K got me $2.3MM, would $10K get me $23MM? Is there a limit? From the archives of Pete Stolcers:

***

Tristan, this situation wakes me shudder on so many different levels that I don’t know where to begin.

What makes this an especially horrible story is that two people at the brokerage firm – and one has a managerial position – told the customer that they would auto-exercise the options and that he should wait until Monday.

Anyone with a working brain would have told the customer to do one of to things:

  • Find a broker-dealer who was open for business and try to buy up to 10,000 shares under 230. I recognize that the customer did not have the buying power to cover the cost, but owning puts than can be exercised should make the margin requirement for that long put/long stock close to zero.
  • But an even better solution – in fact, the solution so obvious that these two people should lose their jobs over not telling the client about it – was to simply fill out a ‘DO NOT EXERCISE’ form. Sure, that would appear to be throwing $13,800 into the trash, but if questioned by any investigator – the truth (inability to buy the shares) should justify the non exercise decision. That step would remove 100% of the risk and kill the problem

But telling the customer to wait until Monday? Can you imagine the anxiety of that customer? When Monday morning arrived he would still have the same problem – dealing with more people who could not help.

Those calls did not have to be exercised and the broker should be held accountable. in the real world, the shares had to be bought – no matter the price.

I’ll save Tristan’s other example for another day.

927
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Exercise and Assignment: Rookie Mistakes

Certain questions never go away

I suppose that’s true because there are always new people beginning to undertake the study of options. Those rookies ask the same questions that many of us raised when we were just getting started.

Today I’m reviewing some of the most basic aspects of options, and am offering a short explanation as to why they are true. One note of caution: This post is for beginners, and if something is true 99.999% of the time, this is not the place to discuss the rare exceptions

These items all relate to the exercise/assignment process.

Let’s begin with a question submitted to Tyler at his blog (Tyler’s Trading).

1) “I know the probability of being assigned before expiration – while there is still time value left in the option – is very slim, but is there still a chance?”

The option owner has the right to exercise that option at any time prior to expiration. That means that anything is possible and that option owners can make mistakes. However, it is best to assume that any option with any time premium will NOT be exercised. Sure, you may get that surprise assignment once or twice over the years, but not often enough to give it much thought.

In fact, when assigned on a (covered) call option with remaining premium, consider it a gift when you can repurchase the stock and re-sell the call. Or, you may prefer to get an early start and sell an option that does not expire in the front month. That gives you that extra premium as a gift (as long as it’s more than enough to cover trading expenses). That is capitalizing on someone’s mistake.

This gift happens more often than anyone would suspect, especially before a dividend. Traders who should know better, exercise an option – just to collect the dividend – and then have downside risk that is far to large for the reward. And the person assigned the exercise notice takes the gift, buys stock and re-sells that option, thereby collecting a premium that is larger than the dividend.

2) Why it’s so very wrong to exercise a call option any earlier than necessary (when puts are very deep ITM, it’s reasonable to exercise the put. This is more true when interest rates are higher.)

When you own a call option, all you can lose is the value of the call. That’s one reason traders may prefer to own calls, rather than stock. The call owner pays a premium in time value when buying the call. Exercising cancels all remaining time value. Why would anyone throw away that time value? Once you exercise, you own stock and can get clobbered when the stock price tumbles. Not exercising costs nothing. The call owner participates in upside movement, and there is ZERO reason to accept all that downside risk in exchange for NOTHING. Early exercise of a call option is a very bad idea.

The one exception (worth discussing now) is that it may pay to exercise early to collect a dividend. Much of the time, it’s still wrong to make this exercise. Do it only when there is ZERO time premium in the option and its delta is 100.

3) For reasons that astound me, some rookies believe that the call owner always exercises when the stock rises and hits the strike price of the option. If you among the tiny minority who believe this is true, let me assure you that it is not. Not only does exercising destroy the large time value in the option (time value reaches its maximum when the option is at the money), but the entire cost of the option is wasted. All the trader had to do instead was place a buy stop order to buy shares if and when the stock hit the strike.

That costs zero and the option is far from free. Even better, if the stock never hits that target buy price, the trader loses zero while the option owner sees his investment become worthless.

Many mistakes are unavoidable as we grow as traders. However, there is no reason to make either of the mistakes listed above.

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Covered Call Writing: Why You Will not be Assigned Early

This post is based on a comment by Jill:

I have a question about covered calls.
I've owned Verizon (VZ) stock for a while. It has a good dividend and is not very volatile. Recently purchased more when it hit a 2-yr low around $26.15. This stock usually moves up or down a few dollars over a few months. It started trading over $27 and I decided to sell options against it for income, and sold September calls with a $28 strike price.

Shortly after a recent earnings announcement, VZ moved up by > $1.50, and is already above $28.

There are almost 2 months remaining on these options and I'm not sure what I'm supposed to do now. Can I have someone go ahead and buy my stock? 

The options are showing a loss but should I close both or do I have to hold them another 2 months? I'd rather get out now if possible but not sure if I can.

Thank you.

(Follow-up comment): Maybe I'm looking at this wrong but my option price is at a loss right now and if I close I'll actually be worse off because of the option – had I not sold calls at all. Right?

For some reason I thought if it reached my stock price I would get the stock gain plus the option income, but I'm actually losing on the stock gain because the option is at a loss. Am I looking at this wrong? Is there any benefit to waiting or do most just close it out when it hits is mark?

***

Jill,

You are looking at this correctly, and raised some very good questions.  However, you did not fully understand the terms of the contract (options are legal) contracts  This is the type of information that beginners must be taught, but almost no one bothers with these details.  I bother, and am happy to explain.

Yes, you would lose money on the option if you closed the position.  And yes, you would have been better off – this time – by not selling the calls.  But do not allow that to bother you.  I'm sure you have had success writing covered calls in the past. And you had success with this trade.  This is a profitable result.  Obviously when you see the current call price, you don't feel that something good happened – but it did.  It is not the maximum possible result that could have been achieved, but it is still a good result.  Would you be happier if the stock were $27?  You shouldn't.  The position is worth more at it's current price than it would be at $27.

If you exit the trade by selling your VZ shares and buying those Sep 28 calls, you will have earned far more on the stock that you lost on the calls. Thus, you earned a profit.

This is a concept that is difficult for some people to understand. That is not a knock on their intelligence. It's a psychological thing; it's a mindset that is difficult to overcome.

Once you sold the call, your new position is a covered call. It is no longer only VZ shares.  It is VZ shares (at its current price), cash (from selling the options) and an obligation that may require you to sell those shares at $28.

Currently, you are making money on that position. You may not have a profit on each part of the position. However, you have a profit on the total position. You earned more on the stock than you lost on the option. That's a good thing. That's how a risk-reducing hedge is supposed to work. You win on one side and lose on the other.  When the win > the loss, you have a profit.

Now, per your question, evaluate alternatives:

a) There is a benefit to waiting. There is also risk. The benefit is collected if and when the option is eventually exercised and you sell your shares at $28. Net cash to you, $2,800 (per covered call)

However, if the stock falls back to 26 (for example), the position would be worth only $2,600.

Thus, the potential benefit comes with risk. That's customary when investing.

b) Most covered call writers do not think about the stock 'hitting its mark.' When you write covered calls, you are doing two things. You collect time premium. Everyone likes that part. You also accept the obligation to sell your shares – but only when the option owner wants to buy the shares.

CC writers think of the stock being above the 'mark' when expiration arrives – not hitting it sooner.

Here is the part that is not understood (or explained to the beginning option trader): You have nothing to say about the timing. The option owner has all the rights associated with the trade.  The option seller has only obligations.

The option owner has the option (the choice) of when to exercise.  He/she also has the right to decide whether to exercise.  There is NOTHING you can do to influence that decision.  You have only two choices.  Wait or trade out of the covered call position by buying Sep 28 calls and selling stock. Trading out of the position is alternative b).

Nearly all the time, the option owner waits until expiration to make the exercise decision. [On occasion the exercise is made early so the option owner gets the stock in time to collect a dividend]. Thus, included in your obligation to sell shares is the obligation to WAIT until the option owner chooses to exercise. You should assume that will not occur before expiration. [You don't learn of the expiration exercise until Sunday or Monday morning following expiration]

To reiterate your alternatives: You can repurchase now, paying some time premium (i.e., when you buy the call and sell the stock, you cannot collect the full $2,800. If you wait for expiration and IF the stock is above $28, then you get the whole
$2,800).

Consider how much more you can earn; consider how long it will take to earn that money; decide on the likelihood of VZ being above $28 when the market closes on Sep 17, 2010. Considering those things, do you want to exit now – or hold?

If you choose to hold, you get to make that same decision every day from now through Sept expiration. You don't have to do the math every day. The point is you always have the alternative of closing or continuing to hold.

Jill this is a basic, but important concept. If you still have any doubts or follow-up questions, please don't hesitate to ask.

[Follow-up]

'Hit the target':  Ask yourself.  Why would anyone buy an option and pay a premium if all that person wants to do is buy stock when it hits the $28 target?  That investor would enter a GTC 'buy stop' at $28.  That order is to buy shares, but only if and when it trades at $28 or higher.  There is no option premium to pay.  No option exercise commission to pay.  If stock never gets to $28, the investor loses NOTHING.  That's much more efficient than buying an option.

I truly hope you can see that no one in his/her right mind would ever do that.  The whole purpose for buying an out-of-the-money option is to see the stock rise well above the strike price.  The plan is to invest a small amount of cash in the option now, instead of investing a bunch of money by paying for the shares. [This person, speculating on the future price of VZ, will never exercise the option.  Instead, he/she hopes to sell it and collect a profit – at some time prior to expiration] 

So if the stock does hit the target, it would be foolish in the extreme to exercise.  The option owner gets all appreciation above $28, so why exercise and come up with $2,800?  No reason.  Why take the risk that the stock price will fall?  The option owner loses only the value of the option – when stock falls. The exerciser loses any time premium remaining in the value of the option by exercising – and also loses on a stock slide.  No one would do that.

I understand why you are asking. This question is not uncommon. But I hope the above explanation makes it clear to you that the option buyer would never exercise when the stock rises to the strike price. There is just nothing to gain and there is a guaranteed loss (time premium in option) plus risk of a substantial additional loss (if stock tumbles).

That's why options cost money.  There are advantages to owning them [there are also advantages to selling, but that's not part of this discussion]

Many people anticipate being assigned as soon as stock hits the 'target' or strike price.  I hope this explanation makes it clear why that will never happen. 

Thus, you either pay that residual time premium now (buy call and sell stock), or wait until September. That's your choice.

750

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Early Exercise: Call Options

I have not posted about the concept of early exercise for some time.
It's amazing to me how this idea gets out of the starting gate and simply will not go away.

Mark,

How would a trader like you decide to do early exercise? 

Say you bought calls when they were trading in the 1.0 -> 2.5 range, now underlying has risen so that calls trade bid-ask at 4.0 / 4.8 and there is strong possibility of it going higher. Also assume in another case that they trade in the 6.0 to 7.0 range.

What would make you wait for early exercise till Wednesday morning, Thursday morning, Friday morning of expiry week as a trader?

Assume you have cash to buy all contracts. The time value is negligible, and theta is eroding it fast.

Would you change your mind if the risk-free interest rate was say 8% and not 0-1% as currently?  Is that rate a huge factor for 2-4 days anyway?

I read some books where a bunch of math experts say that except for a dividend-paying underlying, early exercise is impossible.

Personally, if I were the call buyer and I had bazillion money, I would not sell the calls as the bid/ask spread widens and the market makers play games. I would choose early exercise sometime on late Wednesday or anytime Thursday to remove option spread slippage, so I buy underlying at the strike price and immediately sell it to lock in profit, because underlying spread is narrower than the option spread.

Very interested in your reply.

Thanks

Amit,

***

This is a very easy question.

1) I WOULD NEVER, exercise a call option prior to expiration – UNLESS it is to capture a dividend.

Before I go further, there are three valid reasons why someone may want to exercise a call option early.  My guess is that >99% of all option traders will never encounter these situations. 

If there is a dividend, sometimes a call owner must exercise the option or it is throwing money into the trash.  The call must be ITM, the delta must be 100 and the option should not be trading over parity. 

A professional trader (market maker) may prefer to sell stock short to hedge some trades.  If he/she does not own long stock, then when expiration is near,  deep ITM calls can be exercised and the long stock immediately sold. That is not as good as selling short stock, but must suffice when there are no better alternatives.

When expiration is near and the call option is deep ITM, sometimes the option bid is below parity.  In that situation – and it is not that common because most traders do not hold onto options that move deep into the money – then it's often better to exercise and immediately sell stock than it is to sell the call. 

Selling the call is preferable because it saves commission dollars.  But if the bid is too low, then the trader may have to exercise.

These situations exist, and I mention them for the purist.  However, my contention remains that if you are a retail investor, you can easily go your entire lifetime and never exercise a call option – or have any reason to do so.


A smart retail trader NEVER exercises a call option.  What can be gained?  Think about it.  Why would anyone prefer to own stock and suddenly have downside risk.

If you are assigned an exercise notice on a call option prior to expiration, consider it to be a gift (unless you cannot meet the margin call).

2) If I no longer want to own the option, I sell it.  You seem to arbitrarily hold options until Wed/Thur of expiration week.  That is terribly foolish.  The ideal time to sell an option is when YOU no longer want to own it – not on an arbitrary calendar date.

3) The price paid for the option is 100% irrelevant.  I don't know why so many people get hung up on this.  Assume you own a call option and the price is $6.  Assume you no longer believe the stock is moving higher.  Does the price paid for that option change the decision to sell?  Would you sell if the cost were $2 but hold if you paid $7?  If 'yes,' then you don't understand trading. 

When you no longer want to own a position then don't own it.  Do not hold just because it would result in a loss if you were to sell.  You already lost the money, and holding invites a larger loss.

Bottom line: You either want to exercise your option, or you don't.  You either want to sell your option, or you don't.  The price you paid is ancient history and 100% immaterial.

4) If the time value is negligible, then there is no theta to be 'eroding fast.'  Theta is the erosion of time value.

5) I would never change my mind.  Period.  Exercising a call option is stupid (exceptions noted above).  Just take that as gospel.  It is stupid.  Just sell it when you don't want to own it.  Interest rates do not matter over a two-day period.  But why own stock for two days?  Don't exercise.

6) If the option bid is less than parity (i.e. if you cannot get at least a fair price for the option), then it is possible to exercise and IMMEDIATELY sell stock.  But this involves extra commissions and is probably still a bad idea.

It is NOT the bid/ask spread that matters.  If the stock is 60 bid, you can sell stock at 60.  If you own the 50-call and the market is 10 bid 14 asked, what difference does that make to you if the market is wide.  If you can sell at 10, that is easier and less expensive than selling stock.

If however, the market is 9.90 to 10.10, that's a nice tight market, but does you no good.  You want to sell the call at $10.  So yes, in this example, you may exercise and immediately sell stock.

Exercising calls to own the shares is a trade made by someone who should not be trading options.  One more point – if you were to make the mistake of exercising early, why would you do it in the morning?  Wait until the close of trading.  It is possible that the stock will decline 20 points that day and you would be left holding the bag.  Exercise instructions are irrevocable.

Amit,

I have a problem when responding to question such as these.  If you have been trading for a two years, then none of this should be unknown.  On the other hand, if you have been trading two months, then it is reasonable for you to have not yet considered these ideas. 

When replying, I do not know to whom I am addressing the answers.  It can be someone who just doesn't get it, or it can be to a very eager to learn beginner. 

743

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Book Review: Getting Started in Employee Stock Options

John Olagues and John Summa put together an interesting book.  It's an important read if you own, or know people who own, employee stock options (ESOs).

Getting Started in Employee Stock Options explains that most recipients of ESOs  exercise far earlier than the option expiration date – to lock in profits.  As option traders, all of you know that this is discarding many dollars worth of time value.


Olagues


The two Johns provide much guidance is hedging (reducing the risk of owning) ESOs.  If you can avoid exercising prematurely, there's a high probability that you will come out earning extra dollars by the time you do exercise the options.  If you have been exercising, or plan to exercise some of your ESOs in the foreseeable future, read this book. It's worth your time.

If you have friends or family members who earn ESOs and if they don't understand options very well (or at all), get this book as a gift.  They may not need your help, but if necessary, you can guide them through the basic option concepts. 

The book offers a detailed explanation of how people can hedge their options by using exchange-traded options in the same underlying stock.  Tactics include selling calls and/or buying puts, and the authors recommend trading LEAPS (longer-term options)

Why bother with hedging?  It's an intelligent way to maximize gains from those ESOs.  It makes no sense to throw away thousands of dollars in time premium when there are suitable alternatives.

Unfortunately, if your options were issued by a small company that does not have its options traded on an exchange, then simple direct hedging is not available.

Concerned about tax consequences of your hedging trades?  This book has the answers.

Want to know why companies love it when you exercise early?  There's a thorough discussion. HINT: Early exercise forfeits remaining time premium, and that's a gift to the company.

If there's something you want to know abut ESOs, this book has it.  The authors are not shy, offering their opinions on topics of significance.  The bottom line is that this book is not for everyone, but if you are among those who receive part of your compensation in the form of employee stock options, don't miss this book.  

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