Option Investor
Educational Article

Spring Has Sprung

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By Lynda Schuepp

The weather in New England has finally turned. Haven't seen snow in a week or two and the flowers are popping. I think the market is also starting to bloom. A while ago I wrote about calendar spreads. A reader brought up some great questions about the strategy, which needs clarifying.

Reader wrote:
"I was very interested by your strategy and I did do many simulations on Jan2002 (sell QQQ puts) and Jan 2003 (buy QQQ puts). I simulated the strategies on different volatility levels (20, 30, 40, 50, 60). However, it remains very important to know the margin requirements on the strategy; is it the spread only to be paid or is there a margin on the sale of puts? Moreover, in case we are exercised on Jan 2002 puts (for example in June. 2001) we need the cash to hold or we have to liquidate and lose the opportunity to realize tremendous profits at the maturity of the short leg; i.e. Jan. 2002. I would like to have your reply on these issues."

The reader brings up some good questions that I didn't address, namely exercise risk and margin. First as a review, a calendar spread is a very easy, simple, non-stressful trade. Complete details of this strategy can be found in a two part article I wrote back inFebruary titled: "Calendar Spreads are a Nice Way to Sleep at Night. "A calendar spread consists of a long option with a longer expiration date and a short option with a closer expiration date both with the same strike price and both are calls or both are puts. The example I used was the 80 strike on QQQ's, using Jan '02 and Jan '03 puts. I will continue to use this example in this article.

The reader's questions regard exercise risk and margin. Let's first look at exercise/assignment risk. Before I really understood the process of being assigned, this used to be my biggest fear, getting the stock "put" to me. Let's examine the process of exercising an option. First the person who bought the put phones their broker and says that they want to exercise their option. Why would they do this? Several reasons follow:

1. They want to see what it's like (don't laugh)
2. It was part of a hedging strategy that they are unwinding.
3. It is part of an arbitrage scenario.

The first reason, believe it or not happens once in a while. First "Jo Investor" calls his broker and says he wants to exercise his put. The broker notifies the OCC (the options clearing house for all stock options). The OCC gathers up all exercise notices from all the other brokers in the country and "randomly" assigns them to the brokerages that are short that particular put. The brokerage then receives their notice from the OCC and then they in turn "randomly" assign one of their customers that are short that same put. Chances are you won't be assigned unless you are the type that is prone to win the lottery. Remember, first your brokerage firm has to be randomly selected by the OCC and then you have to be randomly selected by your brokerage firm. If there is plenty of open interest, then your chances are slim to none. This brings up a good point that I didn't go into before. Make sure there is plenty of open interest in the leg you are going to short. If there is lots of open interest your chances of being assigned are even less. If there are only 100 contracts of open interest and there is no time value left in the option, then your chances of getting assigned are greater.

The second reason would be that someone needs to unwind a hedged position. For instance, a mutual fund owns boat loads of the QQQ's that they would like to sell but because they have so many shares to sell it would cause the price to drop, so they would exercise their put and get the full price of the strike they bought. This is typically what happens on expiration day, which is why you don't want to be short an option near expiration. Many "in-the-money" options will be exercised because of this reason.

The third reason is a form of arbitrage, done by the "arb" specialists or market makers, and it helps keep the market honest. For instance, the Jan '02 80 put had a bid of $34.60 and an ask of $35.10 at the close. The stock closed at $45.15 so that the put has $34.85 ($80 strike -$45.15 stock price) of intrinsic value and some minimal amount of time value. There were no Jan' 02 80 options traded on Friday so the market maker can be a tough guy and stand firm at the bid, which in this case is $.25 undervalued ($34.85 of intrinsic value less the bid of $34.60). An arbitrager can buy the stock at $45.15 (market on close order) and exercise the put on the stock he just bought and receive the full $34.85 through exercising the put. Because he bought the stock and exercised the option the same day, no additional funds are needed to purchase the stock. It sounds like peanuts, but this is how these guys make a living.

Now you know why options are exercised, but let's see what actually happens if you are the lucky one to get assigned. You wake up one morning and look at your positions and find out you now have 1000 shares of QQQ in your account. Based on the close on Friday, that would mean you'd have to buy the stock for 80, but you received cash for the short call initially, so you would be out the difference between the strike of 80 and what you sold the put for originally. After you pick yourself back up off the floor, you might start to panic because you are fully margined and you only have $100 in your savings account. Stay calm, you have two choices and neither of them will bust the bank. Remember, stocks have a 3 day cash settlement so you can wait the entire day before acting.

SCENARIO ONE: QQQ's are up in price from the close of previous day. If so, you are in luck!

Step one: You would sell the QQQ's at a profit and because the sale occurs the same day, no cash is needed.

Step two: Determine if the short put still has any time value. If they do, you could then short the Jan '02 put again and sit back and smile. If no time value is left in the Jan '02 put, then you would sell the January '03 put that you are long. Because the January '03 will always cost more than the January '02, it will make up for the loss incurred in your short leg that was assigned.

SCENARIO TWO: QQQ's are down from the close of the previous day. Bite the bullet, you would exercise your Jan '03 long put. The QQQ's you were just "put" are now being "put" to someone else by the exercise of your put. Your loss in this case would be the initial cost of the calendar spread which was $1400, which is the maximum loss you can take. Remember, don't panic, you have all day to watch the stock and see if goes up from the previous day's close. This leads us to the reader's second question regarding margin.

Margin on a calendar spread is zero. The amount of the debit (the original cost of the spread) is taken from your cash account initially, and there is no additional margin maintenance because the most you can lose is the cost of the spread as explained above. Remember the worst case is the stock is put to you, AND the stock is down all day from the previous day. You then turn around and exercise your long put and put it right back to the next "lucky" winner and you're out your original investment.

The lesson here is twofold: First, only sell options that have time value and plenty of open interest. I like to sell long-term out of the money options with at least $.75 of time value. Secondly, never hold a short position close to expiration or the "arbs" will get you!

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