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This is a level 3 question.
I have been writing covered calls and I'm now looking into bear credit spreads. I believe I understand the process of exercise and assignment covered in the standard text and in your Q&A's. However, I've never read how an assignment is performed when someone has an option spread. I am just assuming that brokerage firms will simultaneously exercise my long options to cover the assignment for my short options. At least I hope so. Can you please explain this?
The simple answer is that these are two separate and independent options that have to be individually managed. Just because you may have put the two on together as a spread doesn't necessarily mean that if the one gets exercised the other will also be sufficiently in-the-money to be exercisable. Let's look at some examples that will help clarify this point.
First of all, let's explain what a bear credit spread is. The bear part tells you that it is a strategy that works best if the stock goes lower. Meanwhile, a credit spread is a combination of a purchased option and a sold option in which the sold option takes in more money than is paid out for the option purchased. Therefore, to institute a bear credit spread and to satisfy the above criteria you would need to sell a call at say the 60 strike while buying a call at the 65 strike or any strike above the more costly 60 strike.
Stock currently at 67 therefore
Purchase 65 call at 4.15 and
Sell 60 call at 7.25 for a
Net credit of 3.10.
The risk to this strategy is if the stock goes up. In that case the value of the sold option will increase faster and be greater than that of the out-of-the-money purchased option. Let's work through some scenarios and see the effects that a stock move has on a spread.
The stock moves down by expiration.
In the case of a stock decline to say 59, both options will expire worthless therefore nothing has to be done with either option. However, since you received a credit for the spread that is yours to keep and is your profit.
The stock drifts to 65.50 by expiration.
The stock drifts lower to close at 65.50 by expiration, which makes both options in-the-money and worth their intrinsic values. Therefore the 60 call will end up worth 5.50 while the 65 call will be worth only 0.50. The difference in the spread is 5, which compared to the initial spread price of 3.15 produces a loss of 1.85. Nevertheless both of these options can be exercised. The 60 call worth 5 will automatically be exercised because it is in-the-money by more than $0.75. However the 65 call is a different story. The long 65-call holder will have to state to his brokerage firm that he wants to exercise his call. This notification of intent will then be passed along to the Clearing House. In three business days (T+3) the stock purchase will settle, which will then be matched up and offset against the short call's assignment that you assumed was going to happen.
The stock goes in between by expiration.
In this case, the stock trades at 64.50 at expiration. The 60 call will be exercised because it has 4.25 of intrinsic value. However the 65 call is out-of-the-money and will not be exercised. Nevertheless, the spread holder still has a short option obligation to meet. The spread holder has to sell stock at 60. To fulfill this requirement the short call seller will have to either borrow stock and short sale the stock to the call holder or if he currently holds the stock will have to surrender it.
The stock goes up but the option is exercised early.
In this case the stock advances to 69 sometime before expiration. The 60 call is then exercised early. You get notification the next day of the long call holder's intent. You in turn, think about exercising your 65 call to meet your short call obligation. We have a problem here. The problem is that the stock will settle up on two different days. Yours will settle as customary in three business days. However, one day has already gone by for the long call holder (you got notification a day later as is custom) and he is expecting his stock at 60 a day before your stock at 65 comes. To get things matched up correctly you will have to buy stock and have it settle for the appropriate day while simultaneously selling out your option so as to not incur further risk.
There are probably an infinite number of permutations to the above possibilities but this should give you a fairly good idea of what can happen. Remember they are two separate and independent options that have to be individually managed. Thanks for the question and good luck.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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