Being exercised

[rhmt01]

Hi

I am new to options (however have been trading warrants for a while) and have read a couple of books, and in almost all of them they talk about how being exercised is a very bad thing and to avoid it like the plague (such as "The Secret of Writing Options" by Louise Bedford).

I'm just wondering how this actually works, and wondering if the T+3 system comes into play.

Specifically:

If I were exercised on a written call position, couldn't I buy the stock straight away and pay the brokerage and difference?

or exercised on a written put position, couldn't I sell the stock straight away and pay the brokerage and difference?

I would very much appreciate someone who could walk me through the process of being exercised starting from the point where your broker rings you up regarding a ITM option saying that the ACH has picked your lucky number.

Thanks in advance

 

[wayneL]

Hi,

I'm not sure of the mechanics in the Aussie market as I trade the Evil Empire, but just a terminology thing...

If you are short options you are "assigned" which is what you are talking about. When you are long an option, then you "exercise" you option.

So you don't get exercised, you get assigned.

Cheers

 

[rhmt01]

OK I'll get my terminology right one day. Bedford's book doesn't use the word assign anywhere - she refers to it as "getting exercised".

I've also read Options and Options Trading (Ward) and a few others, but very few of these books deal with assignment, only as a concept of the profitability of early exercise of a bought option.

I wish there was an Australian version covering derivative markerts of "After the Trade Is Made, Revised Ed.: Processing Securities Transactions " by David Wiess, but some things are just something you learn as you go along.

Also in a spread (such as a bull/bear spread), should you be exercised on the ITM component (ie. sold 49 CSL put, bought 48.5 CSL put, CSL underlying 48.90 going ex tommorrow - not that I would do such a thing) what choices do I have with my bought option. If I exercise my 48.5 CSL put would ACH bypass me and assign the writer of the 48.5? (therefore saving me all the broking fees on the underlying).

Thanks

 

[NettAssets]

Also in a spread (such as a bull/bear spread), should you be exercised on the ITM component (ie. sold 49 CSL put, bought 48.5 CSL put, CSL underlying 48.90 going ex tommorrow - not that I would do such a thing) what choices do I have with my bought option. If I exercise my 48.5 CSL put would ACH bypass me and assign the writer of the 48.5? (therefore saving me all the broking fees on the underlying).

Why would you exercise the bought put when it is 40c OTM ?
If you wanted to wait and see if you get assigned why not short sell at $48.90 (and buy an otm call further out in time if you want insurance)

My choice probably would be to buy back my sold position and let the bought put expire worthless.

I was in this exact position on thursday with LHG and proved to myself once again that it is better to close the position a day before where I could have bought the put for half the price that I was forced to pay at close. Its just so tempting to wait when there is only a cent or two to move and everything expires worthless with your money in the bank.
John

 

[sails]

I am new to options (however have been trading warrants for a while) and have read a couple of books, and in almost all of them they talk about how being exercised is a very bad thing and to avoid it like the plague (such as "The Secret of Writing Options" by Louise Bedford).

Being assigned is not necessarily a bad thing – depends on your position and how much the broker charges on the underlying share transactions – and this can vary enormously between brokers.

Example: providing fees are not an issue, assignment on an ITM bull call or bear put spread actually gives max profit without having to do battle with the MM’s to exit at a fair price.

Also, if there is still time value in the option, assignment may not necessarily be detrimental, but if one has to pay hundreds or thousands of dollars in broker fees, then it avoid it like the plague!

Also be aware that if assigned on short calls the day before ex-dividend when there is a liability to pay the dividend. Many of our top option stocks are dividend paying, so it is something to be aware of should you initiate a call spread.

I'm just wondering how this actually works, and wondering if the T+3 system comes into play.

Specifically:

If I were exercised on a written call position, couldn't I buy the stock straight away and pay the brokerage and difference?

or exercised on a written put position, couldn't I sell the stock straight away and pay the brokerage and difference?

Yes, T+3 can be an issue depending on your broker and is the reason the the dividend becomes a liability if assigned on short calls the day before ex-div.

The problem is that assignment actually takes place the day before you hear about it – so you are buying or selling the shares the day before you can exercise your option or physically sell or buy to exit the share position. This means that there will be one day difference in settlement – and some brokers will try to charge a fail fee for that one day. Check with your broker to see what their policies are on the issue.

Example:
Day 1 – the option holder contacts their broker with an exercise request and they physically buy or sell their shares on that day.

Day 2 – the option seller is advised that assignment has taken place and the seller will notice that they are now the proud owner of x no of shares or short x number of shares. Now the option seller has some choices – here are just a couple of the basics:
(a) if the covering long option is OTM or if it still has time value, it is usually better to just buy or sell the shares to close and then sell the covering long if there’s anything left in it. If the covering long is not worth selling, just leave it as a lottery ticket!
(b) contact the broker to arrange exercise of the covering long option if it’s ITM and has no time value left in it - and this will close out the entire position.

Hope this helps!

 

[rhmt01]

Thanks for that sails. There was alot of useful info there

Basically I'm trying to work out what my first spread will be. I'm thinking probably a bull call spread. Definitely a spead due the the whole limited risk thing.

But the key question is what. I have been playing with CSL and MBL warrants for a fair while but I've gotten sick of the market makers. It feels like half the time they know what I hold (with such little volume in installment warrants - they can spot me a mile away and screw me when I'm trying to take a profit. I think they are used to my antics buying 5-10,000 of them for a 1-2 week trade). I feel comfortable playing these underlying but really need to understand how T+3 works as with MBL/CSL, its a matter of $50,000+ a contract should I be exercised and the timing all go wrong.

Should I play in the "sandpit" first, playing with cheap stocks like OSH, SGT and TLS where exercise is costing nearly a twenth of MBL/CSL assignment or is it pretty safe to work with the more expensive stocks and able to deal with the $50k per contract issue due to T+3?

Thanks

 

[sails]

rhmt01, firstly I would suggest that you contact your broker as they really do vary in how they handle and charge for exercise/assignments. Your broker is the one to give you your answer whether you are able to handle assignments on the likes of MBL and CSL as he/she knows your account size and their policies. Make sure you ask if they have any fail fees should you be one day short on payment (last time I checked OptionsXpress don't impose any penalties provided you deal with the assignment the next day). Perhaps check out other option brokers to see if you can get a better deal elsewhere.

With that said, lets take an example of a bull call spread that has gone ITM and one morning there is an email to say you have been assigned. You will find that you are now short (say 1000) shares, but this is T1 for the purchaser of those shares which means that you will received the funds for their purchase one day before you have to pay to close the position - so T3 works in our favour in this instance. (Opposite applies for sold puts where you have to buy a day before you are paid!)

So the next trading day, the shares are either bought to close + you sell your covering long to make up the difference (in the unlikely event there is any time value remaining in it) OR you notify your broker to organize assignment of your covering long option. Either way, you should have the purchaser's payment (based on the relevant strike price) a day before you have to pay for them.

Two things with short calls and bull call spreads:
1. Be very careful with ITM short calls (or even sometimes close to the money) on the day before ex-dividend day (unless you are hedged with shares and are happy to have them called away) as the probability of being assigned and being liable for the dividend is very high.

2. Many option brokers have automatic exercise for ITM long options at close on expiry day unless you advise them otherwise. Make sure you know your broker's policy on this too.

The process of exercise and assignment is fairly straight forward, but the ins and outs of managing them is more involved - and really needs a good knowledge of all the factors affecting option pricing. Jason (aka Synapse)has written an ebook covering a lot of Aussie option information that is generally not covered elsewhere and has some of it for free - check it out: http://www.number.com.au/ebook.html

I'm not a licensed advisor or educator and just sharing from my own experience - but hope it helps a little!

 

[rhmt01]

Thanks again sails, especially for the link

Page 35 of Synapses book goes through some examples of some high value shares being exercised... so its only the difference/brokerage/ach fees that I have to ante up with.

As for the broker issue, I am currently with Avcol, but unhappy with their service. They get quite annoyed when you tell them to start at midpoint of the spread, and slowly move to edge of the MM spread to get a bite. Plus I don't know whats happening with the whole JDV thing and having to re-sign my derivatives PDS/chess/etc... does that mean they've outsourced my to some new brokers in Perth or something?

I am tossing up between either Morrison or OptionsXpress. The US paperwork that OX has sent me is a bit daughting (form W8BN n stuff... next thing I'll get is a W1080 or something from the IRS). And the fact that I can get someone on the phone at Morrison if the s*** hits really the fan has things going for it. There was also a recent ad in the daily telegraph with this new phone broker - www.norrissmith.com.au offering flat rates for everything.

I've decided to spend money doing small trades in the sandpit with small share values for a couple of months. Try every scenario such as intentionally getting assigned on an ITM put and call on something small (underlying <$4) on 1 contract only just to go through the experience of the whole process and lose my "assignment" virginity in a controlled environment.

Reading everyone here it seems the best thing to do is experience it all and learn; the short term spending on alot of brokerage will benefit more in experience and confidence in the long run than running round with $50k exposures with no idea and sleepless nights

 

[Magdoran]

Hi

I am new to options (however have been trading warrants for a while) and have read a couple of books, and in almost all of them they talk about how being exercised is a very bad thing and to avoid it like the plague (such as "The Secret of Writing Options" by Louise Bedford).

I'm just wondering how this actually works, and wondering if the T+3 system comes into play.

Specifically:

If I were exercised on a written call position, couldn't I buy the stock straight away and pay the brokerage and difference?

or exercised on a written put position, couldn't I sell the stock straight away and pay the brokerage and difference?

I would very much appreciate someone who could walk me through the process of being exercised starting from the point where your broker rings you up regarding a ITM option saying that the ACH has picked your lucky number.

Thanks in advance

Hello All,


Tried to post this last night, but the ASF site keeps bugging out, so some of my comments may overlap with Margaret’s post this morning.

Ok rhmt01, firstly, the correct term in Australian terminology is being “exercised”, assignment is the same thing, but the term is commonly used in the US markets.

Secondly, T+3 generally applies to shares and not options. Options are typically settled T+1 (this is true of exercising; the option writer is obliged to fulfil the contract at T+1). Certainly if you have to purchase or sell shares in the process, you will settle these T+3, but the option obligation must be settled at T+1 (that means by the end of the trading day once you receive the notice).

Thirdly, being exercised is often not a bad event in certain circumstances, provided you’ve worked out your strategy and risk correctly at entry. It’s happened to me and it’s no big deal if you know what you’re doing. But certainly, knowing the mechanics is vital if you’re gong to be selling options, so please do study this in detail.

Also, consider that this applies to stock ETOs, and that index options may be European exercise, so these work differently. The comments here refer to American exercise.

How you respond to a sold position being exercised depends (as Margaret has correctly outlined) on the strategy you used, and the market conditions. Sure, to fulfil the contract you can buy the underlying if exercised on a short call, or sell the underlying if exercised on a short put. But if you have a bought position like in a bull call, bull put, bear call or bear put, it may make sense to exercise this position in order to fulfil your obligation if this is to your advantage.

In the case of a bull call or a bear put, if the sold position is ITM and exercised, this usually means that you will automatically realise the maximum profit because you can then exercise the deeper ITM bought position, and pocket the difference (the only cost here is the cost to exercise your position).

Where you are exiting at a loss for say a bull put or bear call, by exercising the bought position you may lose the time value if you exercise it, so consider retaining the bought leg if you deem this to be strategically the best course of action (certainly if reversing the direction has a good probability of success by keeping the bought leg). Alternatively you could wind out the bought position in the options market after buying/selling shares to fulfil the exercised option.

You may also elect to keep any shares you receive if you wish, or just sell the shares you own if for instance you were executing a covered call, and leave it at that, but this is a personal decision based on your broader strategy.

Margaret makes a good point about short Calls being exercised the day before ex-div. This is very common for positions with little or no time value to be exercised around ex-div time. Depending on the conditions (volatility and where ITM/ATM/OTM you entered the position), it may make sense to wind out the position before this happens, because you will owe the dividend in the stock if exercised in this way. However, if the time value premium more than off sets this with longer dated strikes, you can profit from this kind of transaction depending on the dividend, and the premium paid, but you really need to think this through very clearly.

I used to trade warrants too, so be careful when trading low open interest options, they do trade quite differently. You really need to know your Greeks and how to play the market makers since there is definitely slippage and volatility shifts to consider.

Hope this helps

Regards


Magdoran

 

[rhmt01]

Thanks Magoran.

So if I had a position:

Bought RIN 13.23 Sept Call
Sold RIN 13.69 Sept Call

Underlying at 13.90 on the two days before expiry.

If I am exercised on the sold 13.69 call and notified the next day (the day before expiry), if I exercise my bought 13.23 call does it cancel out or would there still be a share transaction?

On the same note, if I had the same position and price on underlying on expiry day and I exercise my bought position and the sold position is exercised would there be any (share) transactions.

I understand that stocks at T+3 and options are T+1, but I am just seeing what the "crossover" is when exercised, as you move from the options T+1 world with either a pile of cash (sold call exercised) or a pile of shares (sold put exercise).

Does that mean I have 2 days (T+3 minus 1 day of notification) to correct the situation (buy or sell) or do I have to do everything the day the broker tells me I have been exercised?

Just trying to understand the timing and brokerage implications of being exercised.

 

[wayneL]

Ok rhmt01, firstly, the correct term in Australian terminology is being “exercised”, assignment is the same thing, but the term is commonly used in the US markets.

Mag,

This may seem to be a pedantic point on the issue of terminology, but has the potential to be an important one.

"Being exercised" be be a term in popular usage amongst retail traders, obviously promulgated by amateur tomes such as Secrets to Writing Options, but it is most definately not correct terminology; not even in the United States of Australia. Unfortunately is has become entrenched in the trading vernacular, but this does not make it correct.

When an option owner "exercises"' their option, the writer of the option is "assigned". This is the correct terminology as this document from the ASX clearly illustrates:

ASTC FAIL FEE WAIVER REQUEST - ASSIGNMENT OF CALL OPTIONS TO UNCOVERED WRITERS
Due to the overnight batch processing of ACH operations, an exchange traded call
option writer is not notified of their assignment until T+1 even though the exercise notice is lodged by the taker (the owner of the option) on the previous trade date (when the subsequent “as
at” equities transaction becomes effective).
If the assigned call writer was uncovered, ie. did not already own the underlying
Financial product, a one day mis-match in the equities transaction settlement may
occur and ASTC fail fees may be incurred.
Given that Exercise notices can be lodged up until 7:00 pm and ACH is unable to
notify assigned option writers within market hours on that same day, ASTC, upon
application, may waive fail fees, which are levied as a result of an ensuing equity
transaction settlement failure.

http://www.asx.com.au/investor/pdf/notices/2004/Clm13504.pdf

There is a very good reason for standardized terminology across all markets and that is to avoid the possibly disasterous consequences of confusion.

The taker (buyer) of the option exercizes.

The writer (seller) of the option is assigned.

Cheers

 

[rhmt01]

I'm just trying to understand how to defensively handle assignment...

From my calculations, the cost of brokerage of the underlying (2 sides) is going to be the big issue especially for the likes of CSL and MBL.

Is it possible (such as 2 days before expiry) once assigned to run out and buy an in/at the money option and exercise that on the same day and avoid any stock transactions (and stock brokerage)?

 

[wayneL]

I'm just trying to understand how to defensively handle assignment...

From my calculations, the cost of brokerage of the underlying (2 sides) is going to be the big issue especially for the likes of CSL and MBL.

Is it possible (such as 2 days before expiry) once assigned to run out and buy an in/at the money option and exercise that on the same day and avoid any stock transactions (and stock brokerage)?

rhm,

I'll leave the brokerage considerations to the others, bit if your sold leg is substantially ITM 2 days before expiry, it is likely that your spread will be in profit by > 90% of its ultimate profitability.

Under these circumstances, here are a couple of reasons to think about simpley closing out the spread and taking the ~95% profit or otherwise sidestepping assignment/exersize.

1/ Your risk/reward is now radically different to when you put the trade on. You now have VERY little more upside potential and a massive amount of downside. The stock could move up $10 and it would mean very little to your overall profit/loss. However if the stock moved down $10, it has just cost you a bundle. Leaving the trade on only to watch the stock move top below the sold strike... or worse still below the bought strike in the days preceding expiry is a major p!ss off.

2/ That 5% or so of foregone profit may just be cheaper than the commission on exercize/assignment... depending on how your broker charges you.

3/ You could roll or morph the position to something else, depending on your view.

Just a couple of things to consider.

<Note; this was added after Netassett posted> ==> As to your question. If you have already been assigned early, you cannot avoid the share transaction and will require on offsetting share trasaction to rid yourself of the position.

Obviously, unless this is what was initially intended, it will introduce a new risk. It must be said however that there must be a financial incentive for the taker to exersize early (unless he is a cerytifiable idiot) such as a dividend payable. Otherwise early call exercize is not likely.

Please note that ITM puts are likely to be exercized early when the share cost of carry exceeds the remaining extrinsic value in the put.

Cheers

 

[NettAssets]

I'm just trying to understand how to defensively handle assignment...

From my calculations, the cost of brokerage of the underlying (2 sides) is going to be the big issue especially for the likes of CSL and MBL.

Is it possible (such as 2 days before expiry) once assigned to run out and buy an in/at the money option and exercise that on the same day and avoid any stock transactions (and stock brokerage)?

Once you are assigned the shares from a sold option position there is no way to avoid a share transfer.

and

Once you exercise your option in a long option position there is no way to avoid a share transfer - one transaction does not cancel out the other.

The only way to avoid a share transaction is to trade out of the option position before exercise happens.
That is to "buy to close" the equal number of contracts to offset a short option position or "sell to close" the equal number of contracts to offset a long option position.

John

 

[rhmt01]

OK thanks for that.

I will just need to calculate getting out of the bull call spread in my calculations as well.

Is there any particular day (numerically) before expiry do the MM start putting up the price of getting out of a spread?

Also, although one transaction does not cancel out the other, I guess they will be matched though in time? (that is, the shares from assigned call and your exercised call)

 

[NettAssets]

From my experience it usually only starts going up on exiry morning and if the shares haven't traded OTM before lunctime expect to be paying at least double the calculated price - at 5 mins to close it could be anything- you may as well forget it and go through the assignment.
John

 

[NettAssets]

In the spreadsheet I use to watch my positions I always add the entry and exit brokerage and fees in to the total investment right from the start. That way I know what the position is going to be on any day John

 

[wayneL]

OK thanks for that.

I will just need to calculate getting out of the bull call spread in my calculations as well.

Is there any particular day (numerically) before expiry do the MM start putting up the price of getting out of a spread?

Just a point. When the vertical spread is left till expirey, exercize/assignement is the only way to crystallyze your profit.

Market Makers do not put up prices before expirey. Any funny business will be quickly arbed away. However the the trading activity of traders exiting option positions prior to expiry may push prices around somewhat.

Option Pricing Models are notoriously innacurate in the days before expity and this is one of the reason why. Just do your summs at the time.

In my trading, anytime I can get more than 90% profit I will close or morph, irrespective of anything else.

Also, although one transaction does not cancel out the other, I guess they will be matched though in time? (that is, the shares from assigned call and your exercised call)

Providing both happen at expiry, yes.

Cheers

 

[wayneL]

...that is, the shares from assigned call and your exercised call)

Just a further point.. see how correct terminology removes any ambiguity?

It is now patently obvious by correct terminology that one option is short and one is long.

Good stuff!

Cheers

 

[Magdoran]

Mag,

This may seem to be a pedantic point on the issue of terminology, but has the potential to be an important one.

"Being exercised" be be a term in popular usage amongst retail traders, obviously promulgated by amateur tomes such as Secrets to Writing Options, but it is most definately not correct terminology; not even in the United States of Australia. Unfortunately is has become entrenched in the trading vernacular, but this does not make it correct.

When an option owner "exercises"' their option, the writer of the option is "assigned". This is the correct terminology as this document from the ASX clearly illustrates:



http://www.asx.com.au/investor/pdf/notices/2004/Clm13504.pdf

There is a very good reason for standardized terminology across all markets and that is to avoid the possibly disasterous consequences of confusion.

The taker (buyer) of the option exercizes.

The writer (seller) of the option is assigned.

Cheers

Hello Wayne,


I remember the opening song early in “When Harry Met Sally” - I say “Tomarto” and you say “Tomayto”…

Sheesh Wayne, you are getting pedantic in your old age, aren’t you? – crypt not big enough these days? Or did you drink too much blood last night? Hehehehe….

Awwww, come on you escaped Californian, in Australia we’ve used the term “exercise” price, but later adopted “strike” price form the states, we used to use the term “share market” which is now interchangeable with “stock market”… we use “exercised” and “assigned” as interchangeable too…

Also, the term can be used in different tenses to describe the situation covering both parties... it really gets down to semantics and language usage.

Sure, the current rules use the term assignment now, but everyone in Australia understands what being “exercised” means, it's been used by the whole financial market since as far back as I can remember, and I’m in my 40s… In the early days of options, everyone I knew used the term “exercised”… Many Australian texts use the term, as does the ASX site (see below).

http://www.asx.com.au/investor/options/trading_information/early_exercise.htm

Here for example is a quote from the ASX site from the link above:

For in-the-money calls where the corresponding put still has some value, the rule used by most of the market is that if the value of the dividend is more than the value of the corresponding put plus interest, then the call should generally be exercised for the dividend.

Writers of call options who want to avoid assignment (being exercised against) may need to either buy back or roll that short call position to another strike in another expiry, being mindful again that the option they roll to is not also a candidate for early exercise.

Examples
National Australia Bank
Ex-Div 7th June 2004
Dividend 83 cents
Share Price $30.31 on last cum dividend date

1. June 2600 Call (deep-in-the-money)
• Corresponding put is worthless
• Interest = 6.4 cents (Strike Price $26.00 X Interest Rate 5.25%) / 365 days X 17 days till expiry
• 83 cents > 6.4 cents
Therefore the June 2600 call will generally be exercised

2. June 3000 Call (In-the-money)
• Corresponding put is 68 cents
• Interest = 7.3 cents
• 83 cents > 75.3
Therefore the June 3000 call will generally be exercised

3. June 3050 Call (In-the-money)
• Corresponding put is $1.09
• Interest = 7.5 cents
• 83 cents < $1.165
Therefore the June 3050 call will generally not be exercised because the dividend isn't large enough.

Also see:

Further, when exercised the option writer looses the stock when exercised. Profit Loss Outcomes of the Buy Write Strategy at Expiry CBA stock price Stock change $31

http://www.asx.com.au/research/indices/buy_write_example2.htm

Really, I don’t think this is an important issue in Australia where the term has been used for decades... but if you feel the urge Wayne, be my guest, but I’ll respond to either term equally like the rest of the Australian financial industry whenever I see the term used...

Yours in Amusement


Magdoran