Market Basics

Overview

The term ‘limited risk’ is thrown around a lot when it comes to options trading and specifically around options spreads. But anytime you are writing an option, even if it is covered, there are potential risks that can far exceed the projected maximum loss on a trade upon which you may be relying.

A limited risk option spread, like a debit spread, credit spread, covered call, or iron condor, is built by writing (selling) options, and at the same time, buying (long) different options to create the desired options strategy.

When you write options, either naked or covered within a spread, those options are at risk of being exercised by the buyer, and that exercise can be assigned to your account for delivery. Being assigned on short call or put options compels you to buy or sell stock for delivery.

Benefits of Options Spreads

One reason to consider an options spread strategy is to allow for a more efficient use of capital, by allowing you to put on larger positions with less money. But more importantly, options spreads give you additional flexibility in the types of market action and volatility conditions you can trade. Instead of just trading long and short, options spreads give you the opportunity to capture time value or benefit from increasing or decreasing volatility.

The Risks of Writing Call and Put Options

First, most brokers require that you have options trading experience and meet minimum financial requirements before your account is approved to write naked options, and you will also need to maintain a minimum balance in your account. You should always make sure that you have enough money to cover the initial margin and consider an additional cushion amount in case the position moves against you. Always check with your broker regarding margin and account requirements before you begin trading.

Second, there is assignment risk throughout the life of the trade for American style options. Typically, options are assigned only when they are deep in-the-money, or when there is an advantage to exercising to capture a stock dividend. Still, an option writer can be assigned anytime up until expiration.

Finally, writing naked options generally requires a margin account, but you can also write a cash-secured put that covers the full value of the position.

Will I Get Assigned?

An options seller never really knows whether and when an assignment will occur. Once written American-style options (put or call), have the potential for assignment, to receive (and pay for) or deliver (and are paid for) shares of stock. In some circumstances, you may be assigned on a short option position while the underlying shares are halted for trading, or perhaps while the underlying company is the subject of a buyout or takeover.

To ensure fairness in the distribution of option assignments, the Options Clearing Corporation (OCC) utilizes a random procedure to assign exercise notices to clearing member accounts maintained with the OCC. The assigned firm must then use an exchange-approved method (usually a random process or the first-in, first-out method) to allocate notices to its client’s accounts that are short the options.

Credit Spread early assignment example – in-the-money exercise

XYZ stock is currently trading at $80 per share. Two weeks ago, you put on a credit spread when XYZ was trading at $92 per share. You wrote 1 95 put for $5 and bought 1 90 put $2.50 for a credit of $2.50, or $250. Both options are now in-the-money, and the 95 put you wrote is assigned to you, and to offset that assignment, you exercise your 90 put. You are flat, out of the position.

Assignment at Expiration Can Be Problematic

At expiration, the buyer of an option is in control and can exercise at any time prior to the cutoff time on Friday expiration. If you hold short options, calls, or puts, into and through expiration, bad things may happen that are out of your control.

Keep in mind that most stock options stop trading at 4:00 pm ET when the regular session closes, but many stocks continue to trade after hours until 8:00 pm ET, even on expiration Friday, which may affect the intrinsic value and possibly the decision of a call or put option buyer to exercise an option.

Here are two examples:

Credit Spread assignment example at expiration – out of the money exercise
It is expiration Friday, and the markets just closed. XYZ stock is currently trading at $96 per share. Two weeks ago, you put on a credit spread when XYZ was trading at $92 per share. You wrote 1 95 put for $5 and bought 1 90 put for $2.50, for a credit of $2.50, or $250. Both options expire out-of-the-money worthless, and you expect to collect your $250 profit. However, for some unknown reason, the buyer of a 95 put exercises, and you are selected and assigned the long stock. Your covering 90 put option has expired, leaving you exposed to the market, and over the weekend, the CEO of XYZ is arrested for embezzlement, and XYZ opens Monday at $50.00 per share, creating an unrealized loss in your account of $4,000 on that position.

Credit Spread assignment example at expiration – in-the-money – do not exercise
It is expiration Friday, and the markets just closed. XYZ stock is currently trading at $89.00 per share. Two weeks ago, you put on a credit spread when XYZ was trading at $92 per share. You wrote 1 95 put for $5 and bought 1 90 put for $2.50, for a credit of $2.50, or $250. Both options are now in-the-money, and you expect to lose $250 on the trade. However, a put buyer somewhere does not have enough money in his account to exercise their put option, so before the 5:30 pm deadline on expiration day, he informs his broker – “Do Not Exercise”; this will cause him to lose the $600 ($6 per share $95-$89). The OCC designates an options writer to offset this non-exercised put, and that contract is voided. However, you were counting on that short 95 put contract to offset your long 90 put, but there is now no short put any longer, and you are auto-exercised and must short the 100 shares of XYZ stock, and you are now exposed to the XYZ price action open on Monday.

How to Avoid Assignment

Of course, these last two examples are somewhat rare and are only worst-case scenarios, but it does happen and does point out some things to consider before engaging in an options spread strategy. First, do you have enough money to cover the costs or margin required to buy or short the stock if assigned? Second, just because you expect your options to expire worthless, do you still want to assume assignment risk over expiration weekend? Third, when your options are in-the-money, are you at greater risk for assignment? Fourth, do you know when your options expire?

To avoid the risk of an unwanted assignment, you can always close the spread prior to expiration, or at least close the short options you wrote, and take a partial profit or loss on the trade. A small loss now is better than a catastrophic loss on the Monday following expiration.

You can also roll your spread position out to a further expiration date and even adjust strike prices if needed. Diagonal calendar spreads might also be an alternative to vertical spreads, where the long option is a further out expiration series and still covers the short option through its expiration.

One of the benefits of trading options is the ability to shape your position to current market conditions and circumstances. If you find yourself constantly worried about an open position, take some action and consider whether your risk tolerance level warrants exploring different investment and trading strategies.

Dividend Risk of Writing Call Options in a Spread

If you are writing a call option in a spread on a stock that pays a dividend, there is additional assignment risk if the call option is in-the-money and/or has less extrinsic (time value) than the dividend payout.

This is a good time to remind you that there can be a lot of moving pieces in an options trade. You should be aware of several factors if you are writing call options on a stock that pays a dividend including: the amount of the dividend, the ex-dividend date, and the impact the upcoming dividend payment may have on the price of the stock and the option premium.

If you are assigned short stock just prior to ex-dividend date, you could be responsible for paying the dividend. So again, it may not be worth the trouble here; you may close or roll short in-the-money call positions prior to the ex-dividend date.

Conclusion

Spending time learning about options spread trading will help you understand how they work so you can be in a position to better manage the potential risks and benefits as you begin trading.

There are some hard questions to ask yourself here; Do you have the risk tolerance to be assigned long or short positions? Are you able to manage the stress associated with the ebbs and flows of the markets and how they might impact your spread positions? If you answered both questions with “no,” then you should consider a different trading strategy.

Finally, when you are trading, you need to be in the game, focused, aware of your circumstances, the risks, key dates and times, where is volatility, what is the stock doing, is there news, is there a dividend or earnings announcement coming up, and what is the overall market sentiment.

In many of life’s endeavors, sports, ping pong, and options trading, long-term success generally depends on being knowledgeable, building experience, and making fewer unforced mistakes.