One expiration date Friday morning, you turn on your computer and notice you are no longer short 10 about-to-expire SPY calls, instead you are short 1,000 shares of SPY. What happened? How does this affect your options trading? Could you have anticipated this happening?
What happened? Almost certainly, you were assigned on your short calls for the dividend (the owner of American-style calls has the right to exercise any or all of his calls at any time up to and including expiration). We’ll look at why later, for now let’s try to understand the implications of this assignment. Given the relationship STOCK = CALL – PUT, we can see that -STOCK = -CALL + PUT. So you are still short the call, with one big difference — the value of the call can no longer go to zero, rather its lowest possible value is the dividend you now owe. On the plus side, you are now long the same-strike put.
Now that you know how your position has changed, what are your choices in trading? You could choose to treat the whole affair as a mistake (i.e. something that should have been exited yesterday) and simply buy back the stock, in effect simultaneously covering the short call and selling the long put. Alternatively you could restore your original position by selling the same-strike put (-STOCK – PUT = -CALL) and then follow your trading plan and do whatever it calls for you to do on expiration (if the short put closes in-the-money and it is cost-effective, you can just let the position expire to close it out, otherwise you’ll need to buy back the stock and maybe the put).
Why were you assigned? The assignment process is random, so let’s look at why someone would exercise his call earlier than expiration. Here is his thought process:
- For all practical purposes, the reason to exercise a call early is to capture the dividend.
- The owner of a call doesn’t collect the dividend, only the stock owner does.
- It turns out there is an arb available to the call owner. Since STOCK = CALL – PUT, it follows that STOCK + PUT = CALL. The call owner can replicate his position by exercising his call (to be long the stock) and buying the same-strike put.
- If the dividend is larger than the cost of the put (and any expenses), the call owner should do so, collecting the difference. This exercise should be done at the last possible time, which is the day before the ex-dividend date.
Now we know how we can anticipate an early assignment — the dividend is more than the corresponding put. You can choose to ignore this early warning (indeed, if you manage to escape assignment, it is a bonus). Alternatively, you can choose to treat the threat of early assignment as an early expiration and do whatever it is your trading plan calls for you to do on expiration.
It is no accident that I started the article with SPY as an example. The SPY ex-dividend date falls quarterly on expiration Friday, making the last possible exercise date for the dividend the Thursday before. The dividend is usually in the range of $0.70 – $1.10, and with only one day of life left in the puts, they can easily trade for much less than the dividend. At least now you will know how to anticipate an early assignment happening and either avoid it or trade it appropriately.