How to Deal With an
Early Stock Option
Exercise Prior to Expiration.
Using the exact prices
from the DEEP IN THE MONEY PUT CREDIT SPREAD that was used in the last article
you can recall that the OPTION STRATEGIST sold the June 60 Puts and bought the
June 50 Puts for a credit of 9.00 ($9000) Keep in mind that when there is a
decent amount of TIME PREMIUM over and above the actual INTRINSIC value of the
DEEP IN THE MONEY June 60 Put the chances of an EARLY EXERCISE are unlikely
since it would be more profitable for the June 60 Put owner to sell the PUT
OPTIONS in the open market. The chance of an EARLY EXERCISE would be more likely
when the June 60 Puts are trading closer to parity and is trading at its
INTRINSIC VALUE with very little or no time premium.
The prepared OPTION STRATEGIST will be aware that the short PUT OPTION is
trading close to parity and can either close out the entire spread for a small
profit or act accordingly if and when the EARLY EXERCISE occurs. Because the
EXERCISE ASSIGNMENTS are done on a random basis there is no way to anticipate
this happening until it actually does as it will be known the next morning when
notification alerts are provided before the market open. If the an EARLY
ASSIGNMENT is executed on this position – the OPTION STRATEGIST would be
notified of the event along with the number shares of ABC stock involved which
can be any partial amount in units of 100 shares per the number of CONTRACTS
EXERCISED up to the number of CONTRACTS that were sold in this SPREAD which is
10 (= to 1000 shares of ABC Stock)
For illustration purposes we will break it down as if all 10 contracts were
ASSIGNED on this SPREAD and that there were 1000 shares of ABC stock PUT to the
STRATEGIST @ 60.00.
The STRATEGIST is now the
OWNER of 1000 shares of ABC for a cost basis of 51.00 (Stock bought @ 60.00
minus the 9.00 credit from the spread which = 51.00 or $51,000) At this the
point the prepared strategist can use several methods to handle this situation.
Keep in mind that any drop in ABC will be protected by the June 50 Puts that are
still owned and the STRATEGIST will participate should ABC rally and will profit
on the STOCK by selling ABC at any price over 51.00
We should recall that the STRATEGIST entered this SPREAD with a BULLISH opinion
on ABC and should the BULLISH opinion remain – the STRATEGIST can just stand pat
and continue to own the stock knowing there is downside protection provided by
holding on to the 10 June 50 Puts and wait for ABC to rise in price. The
difference here is that the out of pocket is substantially greater now at
$51,000 since the STOCK was purchased. The STRATEGIST can sell the STOCK
immediately at the OPEN and go right back into a VERTICAL PUT SPREAD by selling
another 10 June 60 Puts while capturing some more premium along with lowering
the OUT OF POCKET expense back to an even lower amount than the original SPREAD
entry - certainly much lower than owning ABC for $51,000 while remaining in
position to profit from any rise in ABC.
The other alternative for the prepared STRATEGIST would be to close ABC
completely by selling the STOCK along with the 10 June 50 Puts that are still
owned. With ABC trading at 51.00 the June 50 Puts will have a value close to the
entry price they were bought for and although it will not be as lucrative
compared to an ABC rally, the STRATEGIST will also PROFIT by exiting all
positions after the EARLY EXERCISE. (The $9000 from the credit on the SPREAD and
$9000 deficit from the STOCK will offset each other and the amount taken in from
the sale of the June 50 Puts will be pure profit.
We can now see that the prepared OPTION STRATEGIST is armed with three choices
that can take action based on the current opinion for ABC and more importantly
remains in position to profit even though an EARLY EXERCISE has occurred.
Frank Kneipher
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