Tag Archives | call spreads

Trading Traps for the Unwary II

Continuing yesterday’s horror stories, Tristan submitted another:

Something doesn’t seem right about this. I was short the 115-116 call spread in SPY 55 times during March expiration. I was assigned on the 115 call (the short part of my spread) on Thursday after the close (found out Friday morning). This resulted in being short 5,500 shares on Friday morning versus my long 55 116 calls. On Saturday, I was debited from my account a significant charge because I was short the shares when SPY went ex-dividend on that Friday.

Am I responsible for the entire dividend payment for that quarter because I was short the stock on that one day of ex? Seems like stealing. I feel like if I had bought the stock that day, there is no way I would have gotten credit for an entire quarter of a dividend payment. Anyone know how this works?

***

“Anyone know how this works?” This is the stuff that drives me nuts. If you don’t know how it works, why are you trading a product where it is essential that you understand how it works?

Dividends are paid on specified dates. Whoever is short on that ex-dividend date pays the dividend. Whoever owns the shares collects. Very simple, very efficient and it has always been this way. It’s also fair and reasonable – for owners of the shares. When the stock (or ETF) pays a dividend, the stock price declines by that amount. Gain the dividend, lose in the share price. No one gains or loses.

Alas, it’s not so simple for option owners. When you own an ITM call option that should be exercised to collect the dividend – WARNING: NOT ALL ITM OPTIONS SHOULD BE EXERCISED FOR THE DIVIDEND – failure to exercise results in a real monetary loss. The trader who submitted the question above did not know about the dividend, did not know he should have exercised his calls, and donated his money to some lucky trader who had been short those SPY 116 calls.

To reply to the comment: You are correct. If you bought shares that day (Friday) you would NOT get any of the dividend. You would be too late by one day.

I do agree with the lamenter’s opening thought. There is something not ‘right’ about this situation. What’s wrong is that you should not yet be trading options because your education is far too incomplete.

More Questions from Tristan

For instance, what to do if long puts are automatically assigned upon expiration

If you know in advance that you cannot meet the margin requirement, then do not allow yourself to be assigned at expiration. BUY THEM BACK before expiration. There is no solution that’s any easier. If you are not short the options, then you cannot be assigned an exercise notice.

or if short legs are assigned in spreads

There is almost never any reason to be assigned earlier than expiration (other than exercising a call option to collect the dividend). However, this is a recurring problem for SPY options. It ALWAYS goes ex-dividend on the third Friday of the month. Not knowing that – in advance – is just a huge mistake. If you fear being assigned on any position, then the answer is very simple (Honest. This is a deadly serious situation) Answer: Get out of the trade. Do not hold to expiration. Ask yourself why would you decide to hold to the bitter end? It is so unnecessary. For goodness sake, get out when you may be assigned and especially when you cannot meet the margin call.

If you are assigned on one leg of a spread, and if margin is not a problem, keep the position. Someone handed you a gift, and if the stock makes a big move (down if you were assigned on a call option or up if you were assigned on a put option) then you will score a nice big payday. It’s unlikely, but it has happened before and will happen again.

However, if you are unable to hold the trade and must liquidate, do not decide to exercise your long option to get out of the position – unless this option has zero time premium. It is more efficient to buy back the short stock and sell your long calls [Or sell your long stock and sell your long puts].

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.

There is a lot of stuff on your list. The truth is that most people have no need to understand most items on the list. That raises the question that concerns you: Why are people allowed to trade when they don’t understand the rules? And how do you know what it that you must know when there is no one to provide a list.

The answer to the first question is easy. They are allowed to trade because it is profitable for the brokers. Nothing else matters.

There’s not much that the average trader can do about the items on your list. If he/she becomes a pattern day trader (not a common situation), that’s when he/she will learn about those trading limitations.

Most beginners have no need for conditional orders and have plenty of time to learn how to use them.

However, bid/ask spreads and limit orders are essential items. I assume that anyone who teaches options classes or writes books for beginners includes that information. Traders who jump right in with no education may have some painful experiences when entering market orders. Not everyone can be protected. Would you open an account and enter orders with no advance study or preparation? Of course not and there is no protection for those who do.

You have one advantage. You are aware that dangers exist, and although you may not ask every question, you will be frightened enough to ask questions about any situation that occurs to you. That may not be enough – but you would have to be very unlucky to not have discovered what you need to know when you aware that you don’t know what it is that you don’t know.

Some answers

Don’t pay the offer; don’t sell the bid.

Never never never use a market order. Limit orders only.

There is no need for fancy order types. Limit orders and stops (I don’t like stops for option traders) should be sufficient.

Buy back shorts when they get very cheap – just in case you do temporarily go into a coma through expiration.

The Pattern Day Trader classification is not a concern, unless you day trade. And if you do, you will soon learn the limits.

You can get much of this information from your broker. But get it in writing. The people in customer service may be as bad as your correspondent found them to be (yesterday)

The CBOE stories scare the living daylights out of me — I wonder what these traders were supposed to have read to understand/avoid those problems in the first place. It is not asking too much to know when a stock/ETF you are trading goes ex-dividend.

It really seems like trading was designed for people who have a Series 7 broker’s license and know all these nuances.

I understand how you feel. The bottom line is that people are trading – and they intentionally did not bother to learn the rules. They make bad assumptions and get stuck with the bill. When you sell a call option, you must know that the owner is allowed to exercise at any time prior to expiration. It seems to be a natural question to ask – why would anyone exercise early? That’s when the trader would learn bout dividends.

You may be frightened, but it seems to me that you are taking care to learn about lurking dangers.

928

No one is forced to trade. Information is available to everyone.

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Call Spreads: Strike Selection and Trade Parameters

Mark,

I've been wondering what the trade-offs are when one sweeps (for analysis) a simple call spread from FITM, ITM, ATM, OTM, FOTM.

Yes, there's the risk/reward vs. probability trade-off.  But it seems like there may be more trade-offs to consider, such as impact on vega, initial delta/gamma vs near expiration delta gamma, initial vs. later theta, and perhaps even risk/reward : probability ratio may change as one sweeps across the scenarios.

I've been thinking that the best risk/reward vs. probability ratio is probably when one sells the ATM option because it will always have the most time premium and hence selling the more time premium than one is buying in a spread would yield the highest risk/reward vs probability ratio.


[Dave, I don't know what you are saying here.  If you buy a very FOTM  call spread, the probability is almost zero, and that gives the highest possible ratio.  Moving that denominator towards zero increases the ratio far more than increasing the numerator.]

But, it's not clear to me if that's the case or if some of the other considerations neutralize that edge.  Hence, wondering what are the various trade-offs as we analyze a spread at these different strike positions.

Cheers, 

Dave

***

There are plenty of items to consider, and yes, there are trade-offs.  My question is: Does any of it matter?  When choosing to buy a call spread (or put spread), the two vital factors are the trader's outlook for the underlying and the trader's 'style.'

Dave, if you prefer to buy the higher probability, lower profit potential ITM call spread – what factors could convince you to own OTM call spreads instead?  Does theta or the ratio of some Greeks change your outlook?  When you buy a call spread, it seems to be you are bullish.  But that does not mean that all bullish plays are reasonable.  It's one thing to buy an IBM 110/120 call spread when IBM is 121, but buying the 150/160 call spread is also bullish play, but foolish.

The spreads you prefer to trade describe your style.  I know that I would never buy OTM call spreads as a bullish play.  The low probability of success does not fit within my comfort zone boundaries.  And there are plenty of traders who would not want to own ITM call spreads, but those are the only ones I elect to buy (by selling the corresponding put spread, which is the equivalent position).

If I had
mathematical proof that
trading near ATM iron condors improved long-term results by enough of a
factor to make it worthwhile, I'd still find it uncomfortable to trade
that way. 
I'd feel the constant need to make adjustments – despite the fact the
'evidence' telling me that such adjustments are not needed.  Remember, that the human trader must handle the trade.  When uncomfortable or uncertain, how is that trader going to skillfully manage risk?


I agree.  There are trade-offs. However, in the specific strategy that you chose, I believe all such trade-offs are are less important than the fact that a call spread buyer must be right on direction, timing, and sometimes – the size of the move.  The effect of theta or the concern about near-expiration gamma cannot make me prefer a different style of call spread.

Psychological
factors are difficult to overcome.  Can you
take mathematical evidence and convince yourself to ignore discomfort when trading the position?  I cannot.  When trading without the ability to adjust as I think best, then the trader has a set it and forget it' mentality.  That may work for some, but I don't recommend it.'

Don't misunderstand.  There are many situations in which I take advantage of edge – when I find it.  But the idea of moving towards buying OTM spreads is (currently) outside the range of possibility for my style.

I'll take the
smaller reward that comes with feeling good about my trades.  Over the years, I've had
enough sleepless nights to last a lifetime.  I must own a
portfolio that I believe is likely to produce profits.  That portfolio must satisfy my psychological need to not suffer.  Owning nonadjustable positions does not work for me.  Does it work for you?
  There's only one person who can answer that question.

Here is another problem:  Do you know what you want to find by asking these questions? 
For example, can you quantify how much vega risk you would accept to
generate a better delta/gamma ratio?  As you sweep across the strikes
and find changes in the Greeks and Greek ratios – would you know the
'best combination' if you see it?  I wouldn't,  The point in gathering data is to find evidence to prove or disprove a theory.

Agree.  ATM spreads offer the best theta.  That's good if negative gamma is of no concern.

Conclusion

For the true scientific trader, finding an edge to exploit is Nirvana, and that edge should be exploited.  That leaves trading and trade decisions to the computers.  That's not for me.

I admit to being a 'keep
it simple' trader.  Deeper analysis may provide more edge and
that, in turn, leads to better results.  But it does change the rules of the game.

Cheers to
you.  I'd like to offer a more scientific reply, but it's beyond me.

733


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