A well-liked strategy amongst options investors is roofed call writing: the investor buys 100 shares of stock and sells one call option, granting another person the best to purchase that stock at a particular price, often called the strike price, for a limited time. Often, the choice expires worthless and the investor keeps each the stock and the choice premium.

Nonetheless, sometimes the choice owner exercises the choice. Meaning the investor is assigned an exercise notice and is obligated to sell the stock. This achieves the utmost profit available when writing covered calls.

Many investors fear being assigned that exercise notice. They might imagine someone has cheated them since the stock is trading above the strike price. In reality, being assigned early can profit option investors, except in a single case: OEX options. OEX, which trades on the Chicago Board Options Exchange (CBOE), is the ticker symbol used to discover Standard & Poor’s 100 index options.

How an Early Exercise Works

Here’s the hard truth: Being assigned an exercise notice is nothing greater than a notification that you simply fulfilled the duty you previously accepted when selling the choice contract. If you happen to own stock that you don’t need to sell under any circumstances, then you definately should not be writing covered calls.

If you happen to trade spreads (buy one option and sell one other), then being assigned an exercise notice doesn’t adversely affect your overall position. You lose nothing.

In reality, assuming your account has sufficient margin to hold the position, receiving an project notice before expiration can turn into free money once in a while due to the additional profit potential. In other words, if the stock suddenly drops below the strike price, every penny of that decline below the strike is extra money in your pocket – money that you simply couldn’t earn when you were short the decision as an alternative of stock.

The OEX Exception

The above is a relatively lengthy explanation of why being assigned an exercise notice should (almost) never be a priority. As mentioned above, there may be one necessary exception, and that happens while you sell OEX options.

These options are cash-settled, American-style options. All other actively traded index options are European-style and can’t be exercised prior to expiration.

Why is OEX an exception? And what’s the massive deal about being assigned an exercise notice before expiration arrives anyway? Didn’t we just learn that an investor shouldn’t fear early project?

When using equity options, when you are assigned on a call, the choice is canceled and, as an alternative, you turn into short 100 shares of stock (otherwise you lose 100 shares of stock that you simply own). As such, your upside risk is unchanged, but your potential downside profit is increased.

The whole lot changes, nevertheless, if you end up assigned early and the choice is cash-settled. Let’s take a have a look at why this happens:

• When assigned on a cash-settled OEX option, you’re obligated to repurchase the choice finally night’s intrinsic value. (We’ll take a have a look at how this works in the instance below.)
• You do not learn that you could have been assigned until the next morning before the market opens for trading.
• Your position changes. You are not any longer short the choice since you were forced to purchase it—with no advance notice.
• When trading equity options, the decision option you were short is replaced with short stock. Upon project, a brief put position is replaced with long stock. But, when assigned on a cash-settled option, the choice position is canceled and there isn’t any substitute.
• This project notice often occurs as a surprise to the choice rookie, who not only doesn’t understand why anyone would exercise the choice before expiration, but additionally probably doesn’t know that early exercise is feasible.

Protecting Yourself From Early Exercise

Here’s how you possibly can avoid this OEX options pitfall.

Example 1: Losses on an OEX Put Spread

As an instance you select to take a bullish position and sell an OEX put spread (which makes money when OEX stays above the strike price of the choice sold). Assume OEX is currently 560.

Example 2: The Effects of an Exercise Notice

Let’s consider a special scenario. Let’s assume that late one afternoon, about two weeks prior to June expiration, OEX is trading at 500. That is not good because there is a high probability that each options shall be in the cash when expiration arrives, forcing you to take the utmost loss.

But there’s hope! About two minutes after the stock market closes for trading (index options proceed trading for one more quarter-hour), the U.S. Federal Reserve unexpectedly proclaims an rate of interest cut of fifty basis points (0.5%).

The announcement takes everyone by surprise. Stocks have stopped trading for the day on the NYSE, but after-hours trading is going down and stock prices are higher. Stock index futures soar, indicating that the market is predicted to open much higher tomorrow.

The OEX calls increase in price as everyone desires to buy. Similarly, puts are offered at lower prices. The bid/ask prices for the choices change, however the OEX has an official closing price of $540. The index price ignores after-hours trading.

The OEX Jun 540 puts (your short option) was $40 before the news, but now the bid has dropped to $28. Nobody will sell that option at that price.

Why? Anyone who owns the put can exercise it and receive the choice’s intrinsic value (strike price minus OEX price), or $40.

Once you get home from work and listen to the news about rates of interest, you’re elated. What a lucky break for you! If the rally continues and OEX moves above 540, you’ll earn a take advantage of this position.

The Next Day…

You eagerly open your computer the next morning. Sure enough, the DJIA futures are 250 points higher. But, while you have a look at your online brokerage account you notice something unusual. Your OEX position shows that you simply are long 10 Jun OEX 530 puts, but there isn’t any position within the Jun 540 puts. You do not understand and immediately call your broker.

The shopper service rep tells you to take a look at your transactions for yesterday. You realize you didn’t make any trades, but there it’s—right in front of you: You got 10 Jun OEX 540 puts @ $40.

You rigorously explain that there have to be some mistake since you didn’t make the trade. That is when the rep tells you that you simply were assigned an exercise notice that obligated you to repurchase those options finally night’s intrinsic value. With the OEX closing price of 500, you will need to pay $40 for every option. The shopper service rep tells you they’re sorry but nothing might be done and asks why you didn’t exercise your Jun 530 puts when the news was released. But perhaps you didn’t know you would do this.

Your spread is gone. All you could have left is 10 Jun OEX 530 puts. When the market opens and OEX is 515. There isn’t any reason to gamble by holding the puts, so that you unhappily sell the OEX Jun 530 puts, collecting $15 for every. You thought your maximum loss for the trade was $750 per spread, but you paid $25 to shut the spread (pay 40, sell at 15) and thus lost $2,250 per spread ($2,500 to shut the position minus the quantity you collected for the spread firstly, which on this case was $250 per spread), or $22,500 while you account for all the position of ten contracts. Ouch!

It’s too late to do anything within the imaginary scenario above, but now that you simply understand the issue, there are two good alternatives:

1. Don’t sell OEX options.
2. Trade one in all the opposite indexes which can be cash-settled, European style.

In these cases, you can not be assigned an exercise notice prior to expiration and this unhappy event won’t ever occur to you.