Today, our Head of Trader Development, Joe Jensen, answers a question from one of Maverick's traders about getting exercised in a position.*
-----Original Message-----
From: Chris T.
Subject: Getting exercised
Hi Joe,
I have a really quick question for you. I'm in a really nice bull call spread with Goldman Sachs right now and it got me thinking. I've always had it as part of my plan that if the price per share hits my short, then I would exit the position – which is fine if it is the week of expiration. However, in this case it is a June spread. So, if it hits the short this week or next, then (by following my plan) the profit will be about 1/3 of what the max gain would be.
I thought about why I have that in my plan and I realized it's due to a fear of getting exercised. I now have a couple questions about it:
- Do options get exercised often prior to the expiration date or does that never happen?
- Also, if I'm in a spread and they exercise, will Interactive Brokers (IB) just exercise my long and the trade is over? If that's the case, then I really shouldn't have any fear of it and can change that part of the plan instead of exiting immediately because I feel like I might be leaving money on the table.
Regards,
Chris
-----Reply Message-----
Hey Chris,
This is a great question and one that I get often. Getting exercised (i.e., assigned stock) in an option position can be extremely unnerving, especially when you see the amount of margin used and the unrealized profit/loss. There is no real way to tell if you will get exercised. However if you find yourself deep in-the-money (ITM), then the odds do increase.
Remember, options are priced based on two things:
- The amount of intrinsic value (how much an option is in-the-money)
- Plus, the amount of extrinsic value (time and volatility remaining in the option).
For example: ABC is trading at $52/share and a trader owns the 50-strike calls worth 3.00 each. Each option has 2.00 of intrinsic value and 1.00 of extrinsic value. If the trader exercises the option early, then he is actually throwing 1.00 away per option since they will own stock at $50 that is worth $52. They have only 2.00 of value by exercising instead of the total 3.00 of value that the option was worth. Thus, if a trader really wants to own a stock instead of an option, he will dump the calls and simply buy the stock in its place 99% of the time.
Usually, options are exercised near their expiration and only if a dividend is involved. The reason is simply that if the dividend is worth more than the extrinsic value, then it makes sense to exercise the calls early.
If you ever get exercised, it is important to remember to trust in your combo. Vertical spreads are hedged, so take a look at the risk graph and you will see a max gain and max loss point. Even with a stock assignment, you are still hedged due to your other leg in the combo. Essentially, you are still in the same trade...it is just that the stock was substituted for one of the option legs.
If you are ever assigned stock, take a look at the stock chart to see if the combo is still favorable. You can always close this position manually by getting rid of the stock first and then selling the other option. If the combo is ITM (which it probably would be due to the assignment), then you can let the whole thing expire (same day substitution), which would equate to a max gain if you bought the debit spread.
This isn't exactly true for all combos, but if you are in any "combo," then you will be hedged up to a point. Always refer to your risk graphs for help and make sure to add a plan of attack for assignment in your trading plan.
I hope this helps,
Joe
* NOTE: Some original wording has been slightly modified for legibility. Also, the original response was modified to add additional content, including an example.
