Strategy for Owning a Stock After a Binary Event

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Exercise | Assignment
Exercise and Assignment of Stock Options

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Microsoft Reports Earnings Late Wednesday. Here’s How to Profit No Matter What Happens.

Steven M. Sears, steven_m_sears

 

Last Updated October 23, 2019, 5:29 AM

After the stock market closes on Wednesday, it will be clear if Microsoft is too loved or too little appreciated by investors.

 

Microsoft stock (ticker: MSFT) is up some 36% this year, compared with about 20% for the S&P 500 index, making the company’s imminent release of fiscal-first-quarter earnings a critical data point.

 

If earnings are good — and the outlook issued by management is even better — the stock should secure this year’s strong gains and move higher. Any whiffs of weakness that cannot be countered with constructive talk from management could send shares lower.

 

Even now, some analysts are starting to question Microsoft’s valuation. Rather than joining in the debate, investors can use the nascent disagreement to their advantage by crafting a “risk reversal” in the options market, setting them up to buy the stock on a decline while also profiting from an advance.

 

The strategy acknowledges Microsoft’s great strides in the all-important cloud-computing space, which is likely to define how people organize and interact with the digital world. The company’s Microsoft Azure unit is one of three dominant players in the cloud, more than holding its own against Amazon.com (AMZN) and Google parent Alphabet (GOOGL). Microsoft is a worthy long-term position and any price weakness is an opportunity to buy the stock.

 

One analyst who follows Microsoft has even just crowned the company the “King of Cloud.” Yet in classic Wall Street fashion, some investors are concerned the stock has advanced too far, too fast, this year, making Wednesday’s earnings report arguably more critical than usual.

 

Read more: Oracle Is Hiring 2,000 Cloud Workers to Take On AWS, Google, Azure

 

Investors who agree with this column’s thesis could consider selling the October $138 put option that expires Friday and buying the October $139 call option that also expires Friday. (Puts increase in value when the underlying security price declines, while calls increase in value when the underlying security price increases.)

 

This risk reversal — that is, selling a put and buying a strike with the same expiration but higher strike price — generated a credit of $57 per contract when the stock was at $137.83. The strike selection expresses confidence that Microsoft will report good earnings and the stock will advance, as well as comfort in buying the stock at these levels.

 

Should the stock be at $144 at expiration, the call is worth $5. If the stock declines, and the price is at $133 at expiration, investors are obligated to buy the stock or to cover the put. Since the trade was entered into with the intent of buying stock, do just that if circumstances dictate. Of course, the great risk to the trade is that the stock price is far below the put strike price.

 

Our strategy is an example of this column’s time-arbitrage approach to investing. When we find stocks that we think are worthy of long-term ownership, we like using short-term options-trading strategies to maximize market advantage.

 

By selling a put, for example, investors are getting the options market to pay them for buying stock. The long call supercharges the position by positioning for a payout should the stock rally on earnings.

 

It’s a simple approach, and though it has distinct risk factors, the strategy tends to work on stocks worthy of long-term ownership.

 

Microsoft stock closed Tuesday at $136.37, down 1.5%, while the S&P 500 was down 0.36%.

 

The most common scenario for being assigned on a short option is before a stock’s ex-dividend date.  The short call is in the money and has less value than the dividend date.  

Therefore, be careful if you are planning to sell a call in a calendar where there underlying stock has a dividend approaching.  

 

If you sell ( write ) an option and then are assigned, you will be forced to buy 100 shares of the stock per contract at the strike price.  That is, you will be forced to buy 100 shares of the the stock at the strike price.

So if I sold 1 contract on XYZ at 100 strike for 10 dollars and a buyer wanted to “exercise” the contract when XYZ was 80:

I would be obligated to buy 100 shares XYZ per contract at the strike price of 100 dollars when the XYZ was 80 dollars.  

They buyer is exercising their right to 

Buying a Call

Short Calls

Selling a call gives the right to the call owner to buy or “call” stock away from the seller within a given time frame. 

  • If the market price of the stock is below the strike price of the option, the call holder has no advantage to call stock away at higher than market value.
  • If the market value of the stock is greater than the strike price, the option holder can call away the stock at a lower than market value price.

** Short calls are at assignment risk when they are in the money or if there is a dividend coming up, and the extrinsic value of the short call is less than the dividend.
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Buying a Call

What Happens To These Options?

If an ITM call is assigned, 

The call seller will be short shares of stock. 

If the account holder does not have the funds to cover a short stock position, the brokerage will liquidate the stock at the market price. 

For instance, if the stock is trading at $95 and a short call at the $90 strike is assigned, the short call seller would then own the stock at $90 and have to purchase stock at $95 to close the trade. 

The net loss would be $5.00 per contract, less credit received from selling the call initially.

 

If a short put is assigned, 

the short put holder would now be long shares of stock at the put strike price. 

  • For example, with the stock trading at $50, the short put seller is assigned shares of stock at the strike of $53.
  • The put seller is responsible for buying shares of stock above the market price at their strike of $53. 
  • If the put seller can not afford to hold the shares of stock, the broker will liquidate the stock by selling it at the current market price of $50. 
  • The net loss would be $3.00, less credit received from selling the put originally.

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The Greeks

Automatic Exercise at Expiration

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  • Another important thing to know about exercise and assignment is that standard in-the-money equity options are automatically exercised at expiration. So, traders may end up with stock positions by letting their options expire in-the-money.

  • An in-the-money option is defined as any option with at least $0.01 of intrinsic value at expiration. For example, a standard equity call option with a strike price of 100 would be automatically exercised into 100 shares of stock if the stock price is at $100.01 or higher at expiration.

Buying a Call

What if you don't have enough capital?

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  • Another important thing to know about exercise and assignment is that standard in-the-money equity options are automatically exercised at expiration. So, traders may end up with stock positions by letting their options expire in-the-money.

  • An in-the-money option is defined as any option with at least $0.01 of intrinsic value at expiration. For example, a standard equity call option with a strike price of 100 would be automatically exercised into 100 shares of stock if the stock price is at $100.01 or higher at expiration.

Buying a Call

Why Options are Rarely Exercised

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  • At this point, you understand the basics of exercise and assignment. Now, let’s dive a little deeper and discuss what an option buyer forfeits when they exercise their option.
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  • When an option is exercised, the option is converted into long or short shares of stock. However, it’s important to note that the option buyer will lose the extrinsic value of the option when they exercise the option. Because of this, options with lots of extrinsic value remaining are unlikely to be exercised. Conversely, options consisting of all intrinsic value and very little extrinsic value are more likely to be exercised.

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  • Exercising options with lots of extrinsic value is not favorable. Why? Consider the 95 call trading for $7. Exercising the call would result in an effective purchase price of $102 because shares are bought at $95, but $7 was paid for the right to buy shares at $95. With an effective purchase price of $102 and the stock trading for $100, exercising the option results in a loss of $2 per share, or $200 on 100 shares.
  • Even if the 95 call was previously purchased for less than $7, exercising an option with $2 of extrinsic value will always result in a P/L that’s $200 lower (per contract) than the current P/L. For example, if the trader initially purchased the 95 call for $2, their P/L with the option at $7 would be $500 per contract. However, if the trader decided to exercise the 95 call with $2 of extrinsic value, their P/L would drop to +$300 because they just gave up $200 by exercising.
  • Because of the fact that traders give up money by exercising an option with extrinsic value, most options are not exercised. In fact, according to the Options Clearing Corporation, only 7% of options were exercised in 2017. Of course, this may not factor in all brokerage firms and customer accounts, but it still demonstrates a low exercise rate from a large sample size of trading accounts.
  • So, in almost all cases, it’s more beneficial to sell the long option and buy or sell shares instead of exercising. We like to call this approach a “synthetic exercise.”
  • Congrats! You’ve learned the basics of exercise and assignment. If you’d like to know how the exercise and assignment process actually works, continue to the next section!

Buying a Call

Who Gets Assigned When an Option is Exercised?

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  • With thousands of traders long and short options in the market, who actually gets assigned when one of the traders exercises their option?

  • In this section, we’ll run through the exercise and assignment process for options so you know how the assignment decision occurs

  • If a trader is short a single option, how do they get assigned if one of a thousand other traders exercises that option

  • The short answer is that the process is random. For example, if there are 5,000 traders who are long a call option and 5,000 traders who are short that call option, an account with the short option will be randomly assigned the exercise notice. The random process ensures that the option assignment system is fair

  • The following visual describes the general process of exercise and assignment:

Buying a Call

Assessing Early Option Assignment Risk?

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  • The final piece of understanding exercise and assignment is gauging the risk of early assignment on a short option.

  • As mentioned early, only 7% of options were exercised in 2017 (according to the OCC). So, being assigned on short options is rare, but it does happen. While a specific probability of getting assigned early can’t be determined, there are scenarios in which assignment is more or less likely.

  • In regards to the dividend scenario, early assignment on in-the-money short calls with less extrinsic value than the dividend is more likely because the dividend payment covers the loss from the extrinsic value when exercising the option

  • All in all, the risk of being assigned early on a short option is typically very low for the reasons discussed in this guide. However, it’s likely that you will be assigned on a short option at some point while trading options (unless you don’t sell options!), but at least now you’ll be prepared!

Option Basics

Tips and Tricks

A call option will benefit from :

  • A rise in stock prices
  • A rise in volatility
  • An early rise in stock price ( time kills the stock value )

Checklist order

  • Check to make sure volatility is high 
  • Straddle ( then skew if wanted ) the stock price
  • Buy an ITM option and sell an equidistant OTM option
  • Check the premium debit 
  • Calculate the break even price based on the debit
  • Make sure the BE is just around and ideally slightly better than the premium ( premium less than BE for put debit spreads and greater than BE for call debit spreads )
  • FYI- Would rather use strategies that sell premium rather than using debit spreads
  • Set up in low volatility environments
  • Straddle the stock price
  • Buy an ITM option and Sell an equidistant or slightly closer OTM option
  • Set up so that the break even is just around the stock price or ideally even just a little bit better
  • Debit spreads reduce the cost basis of the long option- caps the upside but reduces the max loss increasing your probability of success

Why learn options

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