I want to discuss something somewhat basic that seems to hound me constantly: Retail traders asking me if I am worried about being assigned on a short put position. The very neophyte traders will sometimes go so far as to ask if I am worried about call assignment. I am going to give the short answer on assignment, and then I am going to prove it. Then I will discuss when it is okay to consider assignment. Very quickly, as traders being assigned should be on one of the last things we worry about. The reason being, it isn’t something that happens very often. The circumstances when a trader will be assigned are actually somewhat rare. This is especially true now with interest rates so low. Here is why:
I am going to start with this statement, and it was one of the first things I learned as a trader. A put is a call and a call is a put. Almost every trade pro traders make is converting calls to puts and vice versa. For instance, the protective put: If one charts the graph of a protective put (long put + long stock) what does the trader notice? It looks exactly like a call. The position has a limited loss, and unlimited upside.
Another common trade, the covered call (long stock + short call) looks exactly like a short put. The position has a limited upside and an unlimited downside.
If all combinations of stocks and options can be converted into other positions then there must be some sort of force holding these combinations together. Similar to E=MC2 the option world has a formula that holds it together called put-call parity. Put- call parity is the formula that ensures that traders cannot make more money buying calls than they can buying puts and stock. When options are out of parity, arbitrage begins; this quickly brings options back to parity. This Formula is:
Call-Put=Stock Price-Strike Price+(Interest-Dividends).
The short equation is C-P=S-X+(I-D), the I-D is often replaced with a K for cost of carry.
Using this formula if a customer wants to sell the February 50 call at 9 dollars, with the stock trading 55.00 and a cost of carry of 0.20, what would the put be trading? 9-P=55-50+.20. The put should be trading around 3.80. If the put had a bid of 4.00, the market makers would buy as many calls as they could for 9 dollars, sell the stock against the calls (converting them into puts), then sell the puts. This would allow them to synthetically buy the put and then sell the actual put.
Let’s think about put-call parity and assignment. If I am long a put, and long the underlying against that put, what position do I really have? I am long a call. If I really have on a call then the only way I would exercise my put was if the value of the call was less than the value of the put, stock and cost of carry combination or C If I had bought an ATM butterfly in OEX on January 19th I may have entered into the OEX 500/530/560 put fly. On February 5th the OEX is 40 points lower trading at 491.35, the 530 puts are trading 41.50. With a market maker interest rate of .25 and a cash accrued dividend of about $2.95 our cost of carry ends up being about -2.90. The calls are trading .15 cents. Would I exercise the puts? Is .15<491.35-530+(-2.90)+41.5? 491.35+530=(-2.90)+41.5=.05. The answer is NO, thus despite a MAJOR down swing it is not in my counterparties best interest to exercise the put. With interest rates this low assignments are few and far between. The Market Maker rate will have to increase by at least 1% before this position becomes a somewhat attractive exercise candidate, even with an 8% down move. Hopefully by now one can see there are few scenarios where the put should get assigned to seller. Calls are a slightly different story, non dividend paying calls should NEVER be early exercised. However, traders are at risk of assignment if the underlying pays a dividend. Take EXC for instance, on February 11th EXC goes ex-dividend paying 52.5 cents per share. If I am short the 40 calls should I worry about getting assigned? I can figure it out by plugging the numbers into put call parity. The call is trading around 4.25, the put around .05. The stock is trading 44.25 and the cost of carry ends up being (.01-.525). Now that we have run through the math traders should certainly be clear about how to tell if they will be assigned, using slow long hand. I will give you what I am calling the ‘Traders Short Hand’ to figure out assignment: Traders have many risks associated with a position. It is important to concentrate on the most important risks, while ignoring the insignificant risks. In almost every case, save dividends, assignment risk is at or near the bottom of trader’s risks. Sign up for email updates, please support our sponsers, sign up for the forums, check us out at Seeking Alpha, and follow us on twitter-ID @option911! DONT FORGET TO CHECK OUT EXPIRING MONTHLY and follow the E magazine on twitter @expiringmonthly Popularity: unranked
Plugging these numbers 4.25-.05=44.25-40+(.01+.525) the 40 calls have a problem, the C-P does not equal the S-X+(K). Those calls will likely get assigned to me.
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{ 5 comments… read them below or add one }
Mark,
Thanks for the explanation, and I understand what you’re saying. For some reason, I thought you had put on the FEB OEX spread, not the MAR. With the FEB OEX, the premium you would have received would have been much lower for the ATM put, and a big down move like 8-10% could get exercised and potentially cause heavy losses. My bad – I misread your post in my cursory look.
The even the FEB would not be an exercise rates are SUPER low
I’m not saying the risk of exercise wouldn’t be small, in terms of probability, but the risk in terms of potential damage would be huge. The OEX FEB 490P would have sold for about 8-9 (?) at the end of last week. If there were an 8% drop in the OEX, that would be close to a 39 point drop, and I’m guessing the extrinsic value of the option would then maybe be 2-4. So the chance the option gets exercised would be very small, but the potential damage would be enormous if the market made a violent comeback (which would not be inconceivable).
With that much potential loss relative to margin or premium gained, it would not be in my nature to place the trade in the first place. I normally look at how much damage can happen to my portfolio if the market can move 10, 15, and 20%
Sina,
you would still be delta neutral on the trade because you have the puts. Infact, it would be better for you if the market rallied becaus you would be longer on the way up. do the math on the move. You end up better on the rally
Mark, nice post as usual. Here’s is one thing a retail trader needs to be aware of: getting assigned can very much change the nature of the trade AND can be a problem if you’re not paying attention.
Here’s what recently happened to me. Back in the spring I had put on some long term bear call spreads on the Eurodollar (interest rate options, not currency). They were expiring in the end of 2009 and Mar/Jun of 2010 (if memory serves me right). They were small positions of 1 or 2 contracts and maximum loss was less around $500 – $1000 per trade.
I wasn’t paying attention to my 2009 position and the short call went in the money and time premium went to zero.(Obviously the time premium didn’t suddenly go to zero. It was just a small trade that I neglected for too long!) I got assigned and suddenly was long 1 future. Now this particular future has a multiplier of 2500 so the asset value is very high. I no longer had a limited risk position. In fact I had a position that could potentially lose way more than my initial risk. Fortunately for me, I saw the assignment notice when it happened and closed out my long future and all was fine.
BUT for someone who isn’t watching their position, OR is physically incapable (internet access problems, health problems, who knows?) the results could be quite different.
In the end, it’s not assignment that can cause the problem, it’s not monitoring your positions that can be the trouble. Just something to be aware of.