Exercise and Assignment. It’s Still a Stumbling Block for Rookies

This post is a continuation of a previous discussion that began with this comment:

Hello
Mark, appreciate your advice. As someone new to option trading, I have
a fairly basic question. Let's say I am short naked SPY puts, say 105
strike price, and I shorted/sold them at $0.20. The puts are going to
expire worthless and instead of buying them back, I will get
assigned/or get long SPY from $104.80?

Is this correct? This would
obviously seem too easy to make money. Thanks in advance.

***

My original reply can be found here:

***

Steve continued:

Thanks for the quick response. I need to read up on this stuff is my
conclusion.

If the puts expire worthless (ie SPY closes above 105 at Option Exp), I will
not necessarily be assigned is what you are saying? [NO.  I am saying you will NOT be assigned. Period.]

I think I
understand, but I'll try…

And in Scenario 1 , I'm not assigned and I just keep my premium.

In Scenario 2, I get assigned and get long at 105, what happens to the
premium? [It is is your brokerage account.  It remains there.]  Let us say I shorted the Jan SPY 105 puts at 5. And Let's say that
next week SPY closes (Op/ex) at 110. If I didn't keep the premium [but you did keep the premium.  That's the basic point when selling options.  you keep the premium], does
this make me break even? Do I need a close above 110 to make money in
this case? [NO]

I don't want to make this more complicated, just trying to
get a hold on things. I'm obviously into a situation I do not know
enough about (luckily its not a losing trade).

Thanks again,

Steve

***

Steve,

My belief is that you are over-analyzing this – wanting to be certain you don't miss anything. But you did make one HUGE mistake – and lucky for you, it won't cost you anything.  You began to use options without really understanding what you were doing.  You signed an enforceable contract without reading it or having anyone explain the contract details to you.  Does that sound like the right thing to do?

I can set you straight.  You are missing some easy-to-understand information.  I am probably providing too much detail, but read this slowly.  You will get it.

1) If SPY finishes above the strike price, the chances of being assigned an exercise notice on a put option are essentially zero.  It's remotely possible that you can be assigned an exercise notice if SPY finishes at $105.01 – but that is a very, very remote possibility.

2) You may safely assume that you will never be assigned on an OTM option. 

3) This is the key: Remember the option owner has the RIGHT to exercise.  Put yourself in that person's position.  Why exercise the right to sell shares at 105 when he/she can simply sell shares in the open market – AT A HIGHER PRICE?  Exercising would be foolish.

4) Yes. 
In scenario 1, you just keep the premium.
In scenario 2, you just keep the premium.
You ALWAYS keep the premium. Period.  Always. No exceptions.

Thus, you never have to think about that premium again.  When you collect it, it is yours.

The premium is your payment for accepting the obligations that result from selling an option.  In the current scenario, you are accepting the obligation to buy SPY shares at 105 – at any time that the option owner decides to sell those shares to you (by exercising the put). You were paid $20 to accept that obligation.  Other people were paid varying amounts to accept that same obligation.

If an owner of SPY Jan 105 puts wants to exercise, he/she does not ask your permission, he issues no warning.  The option is exercised.  If your account is selected (random process) as the account that receives that exercise notice, then you must buy the shares.  There is no escape from that process.  If another account is selected, then you are not assigned that exercise notice.

If you are eventually assigned an exercise notice and want to know your cost for buying the shares, that's the time to subtract that premium from the strike price (the price you paid for the shares).  In this case, you would own the shares at a net cost to you of $104.80.  But – this may be a technicality, but this is how the world operates – you pay $105 per share, but received an earlier payment of $0.20.  Net cost: $104.80.

The premium has not 'gone' anywhere.  It is in your brokerage account.

5) This is where you are making it complicated.  You sold an option.  If you don't buy it back at some point, there are only two possibilities.  The first is that the option owner exercises and you are assigned an exercise notice.  The second is that the option expires worthless.

One other point to avoid confusion.  The identity of the person who bought your option does not matter.  All SPY Jan 105 puts are identical.  That means they are fungible. You are separated from that option buyer as soon as the trade is cleared.  That means you and the buyer are no longer connected in any way. 

You may be assigned when anyone exercises.  It's a random process and there is no need for you to know any more than that.  At least not at this point in time


If the option expires worthless, that's the end of the story.  There is nothing else you have to know about the premium or about the final closing stock price.  Nothing.  The option has expired, your obligation to buy shares has ended, and your profit equals the premium collected.  It does not change anything if you collected that $0.20 or the $5.  The option has ceased to exist.  The premium is in your account. How can it possibly matter at which price the stock closes next Friday?  The cash is in your account, no one is going to come and take it away if SPY is 109 or 111 or any other price – once the option has expired worthless. 

There are no further details to concern you.  You made a bet.  You won.   It really is just that simple.  No contingencies, no other worries.  That's it.

Try to understand these points:

You always keep the premium – no matter what else happens

If the stock (ETF) finishes above the strike, the put expires worthless

It does not matter how much the premium was; it's yours.  Remember other traders sold these puts at various times and various prices.  None of that matters.  You are all in the same boat.  The option is worthless.

It does not matter whether the stock finishes at 106, 108, 347 etc.  The put option is worthless

There is no break-even when the option expires worthless; there is only profit.  That profit is the premium you collected earlier

Please tell me you get it now.

574


3 Responses to Exercise and Assignment. It’s Still a Stumbling Block for Rookies

  1. JC 01/10/2010 at 7:02 PM #

    Dear Mark:
    At the end of December, I sold calls on 1/2 my
    position on MGM, they are the February 10, at a 12 strike price. I received .30 per call contract. I thought it was a decent sale because at the time MGM was at about $9.50, a little below where I purchased the shares. My rationale was at the 12 strike, that would be around a 30% return if MGM reached the strike price and the options executed PLUS I received a little over 3% for the sale of the call option. And that is in less than 2 months?
    Your thoughts? Was this a reasonable strategy?
    Also, I have a nice position in MO that has appreciated nicely (plus a 7% dividend) that I would love to sell some calls on, but the problem is you cannot get a decent premium on the calls to make it worthwhile………..unless you go 6 months out. Any thoughts on selling MO covered calls?

  2. Mark Wolfinger 01/10/2010 at 7:31 PM #

    1) ‘February 10’ is confusing. Most would take that to mean Feb expiration, strike price of 10. But I see what you mean: ‘MGM Feb 12 calls’
    2) Very reasonable trade. Very.
    3) Writing calls on a non-volatile, dividend-paying stock such as MO, is never easy. There is no reason for anyone to pay a ‘decent’ premium.
    My thoughts are probably identical to yours: If the premium isn’t good enough to satisfy your needs, then forget about writing calls.
    I have no objection to selling Jun calls. It fits into my comfort zone. The big question is: does it make you uncomfortable?
    The problem with selling calls with a small premium is that you get very little for sacrificing the upside potential. This is not an easy decision.

  3. Steve 01/25/2010 at 6:37 AM #

    Hi Mark, thanks for explaining this as simply as possible. I do get it now. And will be picking up your book soon so that I am better equipped for these option trades. Appreciate your time and help!
    Steve