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Should you worry about having your short options exercised?

April 2004
Dr. Terry F. Allen
www.terrystips.com
 

 

The short answer is "no". The long answer is also "no".

First-time option traders are often frightened by the specter of someone taking away their stock by exercising an in-the-money call. Many feel that they must maintain a large cash reserve to protect against such an event.

Many of these fears are based on their experience of owning stock and writing calls against the stock - early exercise results in their losing the stock (and incurring a taxable event if their original cost was lower).

In the option market, these fears are unfounded.

First of all, the holder of the option is almost always better off by selling the option rather than exercising it. For example, if someone owns a soon-to-expire 80 call, and the price of the stock is $81, he could exercise his option and get the stock, making a $1.00 profit (less what he originally paid for the option, of course). Or he could sell the option for at least $1.50 or more, depending upon how much time there is until expiration. Right up to the last hour, there will be a time premium in that option that he would lose if he exercised rather than sold the option.

Only if you fall asleep or are lost without a phone in Antarctica will you have your stock taken from you if you don't want to.

At least this is true if you are trading options in liquid, (i.e., active) markets. In some inactive option markets, there are inefficiencies. The option market for an inactive stock may be entirely controlled by a single market-maker who is greedy, and not willing to pay a time premium close to expiration. In these markets, it may be necessary for an option holder to exercise to get the price he deserves. To avoid this possibility, stick with actively-traded options (QQQ and DIA are perfect ones, as you never to have to worry about exercising).

What happens if you are exercised?

In the event that an exercise does take place, you should celebrate! You actually come out better than if you had to buy back the short option. Exercise eliminates the time premium you would have to pay. Your actual net cost is the intrinsic value of the option (the difference between the stock price and the strike price).

So what if you are employing my 10K Strategy, and you own a LEAP rather than stock? In this case, your broker will sell (short) enough shares to satisfy the option-owner's desire to get the stock at the strike price. The very next day, you will have short stock in your account as well as the cash which the option-exerciser paid to get those shares. You simply buy back the short stock, using the money that was paid to you when you sold it short.

Let's use an example. You have sold 10 July 80 options short, and the stock is selling at $81 just before expiration. If you bought back these options, they would be selling at just above $1 - let's say $1.25 since there is still time premium in options up until expiration. It would cost you $1250 plus commissions to buy back the options.

If you get exercised, you sell the 1000 shares short for $80 each, or $80,000 plus commission ($15 using OptionsXpress.com). You then buy back the 1000 shares in the market for $81, paying $81,000 plus commission. Your net cost was $1000 plus commissions rather than the $1250 plus commissions you would have paid if you had purchased back the options instead.

This works in an IRA as well, even though you are not technically allowed to short stock in an IRA. Your broker will insist that you buy back the short stock on the very next day, however.


Will I lose my LEAPs?

If you are lost in an African jungle on expiration Friday, and your short option is exercised because you do not buy back an in-the-money expiring option, your broker will still not look to your LEAPs for payment.

Instead, the proper number of shares of stock will be sold short in your account, and you will be asked to cover them (buy them back) on Monday. Again, this is true even if you are trading in your IRA account, which does not allow margin loans or short stock.

If you are still lost in the jungle, your broker will buy the short shares back for you before ever considering a sale of your LEAPs (unless you have no other free cash in your account). In short, your LEAPs are safe unless there are no other cash or more liquid assets available for the broker to sell!

(This is exactly the same position you would be in if exercise had not taken place).

 

One caveat. If you are short shares of stock, even for one day, and that day is the ex-dividend day (i.e., the day when owners of the stock are entitled to the dividend), you will be assessed the amount of the dividend.

The only time this is likely to be any sort of problem is with DIA, which pays a monthly dividend, and the ex-dividend date is on expiration Friday. The amount of the dividend is small, so it doesn't hurt much, but needs to be recognized. If you are short an in-the-money call on DIA during expiration week, it would probably be best to buy it back before Thursday.

For most stocks, a quarterly dividend is more common, and the ex-dividend date rarely coincides with the expiration date. Furthermore, on the day following an ex-dividend date, the stock usually falls by the amount of the dividend, so when you go to buy shares to cover your short stock, the price will be lower than it would have been before the dividend charge. Once again, the net effect is about the same - regardless if you buy back the option or are exercised against

Dr. Terry F. Allen

learn to trade
www.terrystips.com
email Terrys Tips

Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument. We do not and cannot offer investment advice. For further information please read our disclaimer.

 




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