--- In OptionClub@yahoogro
<christianhgross@
> Lets say that I am putting on a spread (regardless of the type) on a
short time horizon (eg next expiry). If the spread is an American option
then you run the risk of getting an exercise against you no?
Yes, that's right. If you want a really good explanation, Christian, I
suggest reading Natenberg's "Option Volatility and Pricing", Chapter 12.
Here's the short version, as it applies to stock options only (not
futures, FX, etc.):
* If you are short a call, you are likely to be assigned the day before
the stock goes ex-dividend. Why? Because:
call value = intrinsic value + interest rate value + volatility value
- dividend value
The first three can never be less than zero. But the day the stock goes
ex-dividend, the price of the stock will be reduced by the amount of the
dividend, and so the call will drop in value. Therefore, the buyer will
want to either exercise the call the day before the ex-dividend date, so
as to hold the stock and receive the dividend; or sell the call, if it
still has significant time value left, and buy the stock separately.
* If you are short a put, then:
put value = intrinsic value - interest rate value + volatility value +
dividend value
Only the interest rate can reduce the value of the put. If the buyer of
the put exercises it, he's short the stock but has received cash for
selling it; and that cash earns interest. Therefore, if the interest
amount exceeds the remaining time value in the put, then it's better to
exercise. This is likeliest to happen close to expiration, when there
is little extrinsic value left. So if you're short an ITM put which has
a delta of -90 to -100, you're very likely to be assigned.
Note that if the ex-dividend date is coming up, the buyer of the put
will probably wait until after that date to do the early exercise, so as
not to be responsible for paying the dividend (as he would if he were
short the stock instead).
* Having said all that, if you are short any American-style option, put
or call, ITM or OTM, you can be assigned at any time. It's the buyer's
right to exercise his option whenever he wants, even if it's not
rational to do so.
However, if that happens, then you should welcome the assignment,
because the buyer has just given you a gift of the remaining time value
in the option! You can simply unwind the resulting long or short stock
position, sell the option again, and be back to your earlier position,
only with a profit in hand.
> After all if the option is in the money and it looks like the market
might drop I might be tempted to exercise and lock in profit.
No! You'd be locking in a loss, or at least losing part of your profit,
by giving away the remaining time value as I described above. If you're
worried about the market going against your long option, just sell the
option. That way you receive the full intrinsic plus extrinsic value of
the option.
(Unless you're long something that I sold you, in which case you
definitely should exercise! :-)
Martin
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