Beware of These Two Risks If You Write Options
Last week I wrote about the risk of writing a put option and a way to manage that risk. This week I want to discuss two other risks that beginner option writers should be aware of.
The first is assignment risk.
Assignment at Any Time
Before we begin, understand that there are two main styles of options: European and American.
The most important difference between the two is that the European-style option can only be exercised at expiration. On the other hand, the option buyer/holder can exercise an American-style option at any time before and at expiration.
Almost all stock and exchange-traded fund (ETF) options you can trade are American style.
Thus, when you are writing a call or put option against a stock, beware that the counter-party can exercise this option before the expiration date. If you are not vigilant, an early assignment can hurt you.
An Unpleasant Surprise
Suppose that in April you wrote five contracts of the Snap (NSDQ: SNAP) July $15 calls because you think the stock will go down when it reports earnings. The stock was trading for about $13.50 at the time and you collected a nice $600 premium for the trade.
However, soon after that, the company issued a good quarterly report and the stock jumped above $17. Since the option doesn’t expire until July, you feel confident that the stock will pull back so you decide to leave the position open.
But then a few days later, when you log into your account, to your surprise you find that you are short 500 shares of SNAP!
The counter-party who bought the call option from you decided to exercise the call early.
Forced Short Sale
To execute the option assignment, your broker “sold” 500 shares of SNAP from your account to the option buyer. However, since your account didn’t have any shares to begin with, you are now short 500 shares of SNAP. You need to buy them back at a future time.
Keep in mind that depending on SNAP’s price movement and how levered your portfolio is, this scenario is not automatically bad for you.
For example, if SNAP falls, you may even be able to cover your short position profitably. But the key point is that the unexpected assignment you don’t exposes you to the risks associated with short selling. The risk is even higher if you don’t monitor your portfolio closely and the market goes against you. An early option assignment could really end up hurting you.
Note that assignment risk doesn’t only pertain to early assignment. If you are short a call or put that’s in the money, and you do not close your position, the option will be exercised at expiration and you will be exposed to the same assignment risk.
Assignment or No Assignment?
The second risk is expiration risk.
The expiration risk comes into play when the underlying stock is trading right near the money (at the option’s strike price) at expiration and you cannot be sure whether the option will be exercised or not. If you take action (or don’t take action) in anticipation of option assignment (or non-assignment), and the opposite happens, you could be exposed to additional loss.
Let’s continue with the above SNAP example. Imagine that it’s July 17 (expiration date) and SNAP is fluctuating between $14.98 and $15.02 in the final minutes of trading. It’s impossible to predict if it will end up in the money.
You consider buying to close your option, but the option sellers are asking for a high premium and you don’t want to overpay. You decide to just buy 500 shares of SNAP in anticipation that the call option will be assigned. That is, you’ve turned your position into a covered call.
However, come Monday you find that the option holder did not exercise the option after all. You now have 500 shares of SNAP that you don’t want.
The Options Clearing Corporation (OCC) generally will automatically assign an option if it is in the money by at least $0.01. However, sometimes the option holder will instruct the OCC not to assign an option if it’s in the money by less than a certain amount.
Guessing Wrong the Other Way
The opposite could also happen. You think that the option will not be exercised, so you do nothing. But then you find that the option holder did exercise the call and you end up short 500 shares of SNAP.
In both scenarios, you aren’t guaranteed to lose money. If SNAP moves in your favor, you could close out the unintended long or short position profitably. But again, you are exposed to potentially more losses if the stock moves against you.
Used properly, the option writing strategy is a good way to generate income. Having a good understanding of the risks involved will help you make better decisions and not get caught unprepared.
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