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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