Option Investor

Option Basics - Early Assignment

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Regarding the Estee Lauder (NYSE:EL) Position:

One of our readers asked about the possibility of early assignment (in the short APR-$45 calls) and while it is a concern, only in relatively few cases will a short option be exercised prior to expiration. Beyond the occasional random assignment, the underlying issue for a sold call would have to be "deep-in-the-money" before there was a significant probability of early exercise. By that time, adept position management would have likely have forced a trader to exit or adjust the play (again) to limit potential losses.

Of course, there are occasionally large (gapping) moves in the underlying issue which simply can't be avoided and that is why you are required to have a specific amount of money (or collateral) in your account; for the obligation of purchasing the stock if it becomes necessary. However, it is rare that a trader is required to pursue that course unwillingly - it is more common for the funds to be used to close/adjust the short position in adverse circumstances. In addition, there are ways of offsetting an unexpected stock assignment and a good broker can often help you resolve a condition that requires an infusion of cash to rescue a particular "play gone bad."

Despite the low probability of early assignment, it is important to completely understand the manner in which your broker handles that type of event. This knowledge will allow you to make effective decisions, before the price of the underlying issue changes for the worse. With regard to sold (APR-$45) call options in the EL spread, we hope they will expire worthless but if they are in-the-money on Friday afternoon, we may need to buy them back to eliminate the (potential) obligation of providing the underlying shares. One thing to consider: equity options which are in-the-money less than $0.25 are not automatically exercised. Thus, if EL ends the week below $45.25, it may not be necessary to close the position with an option order. Obviously, that's a personal decision based on your near-term outlook for the issue and available portfolio capital, however many traders profit from this condition on a regular basis through the use of a short-term (premium-selling) strategy. Without getting into detail, they sell both call and put options (short strangle) when they believe a stock will "peg the strike" at expiration. As long as the share value finishes the expiration period near the sold (options) strike price, the technique is generally successful. Regardless of which approach you favor, the mechanics of option assignment is an interesting subject and we'll talk more about it in a future narrative.

MCM Staff

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