Do you know what to do when your credit spreads get assigned?
At the Raging Bull Summit, I had a chance to meet with members and field some great questions. With stocks having their worst two-day drop in years, I obviously got a lot about what’s going on and what to do.
Also mixed in with some great conversations!
One question I thought was rather interesting. Someone had sold credit spreads into the drop to collect premium. As expiration approached, they got assigned a whole lot of shares.
Befuddled, they weren’t sure what to do. Although I can’t give anyone specific advice about their accounts or actions, I noted that best practice is to collapse the trade immediately.
I realized I don’t talk enough about what to do when your option credit spreads get assigned. So I want to rectify that. You should understand not just what to do but how to avoid it as well.
Option assignment occurs when someone that bought a put or call executes the contract. If you sold someone a put contract, they obligate you to purchase shares of stock. A call contract will force you to sell them shares.
Note: If you don’t own shares for a call contract, the broker will force you to sell short.
When we create credit spread trades, we cap our risk by buying a put or call contract below or above the strike price of the contract we sold.
This creates what’s known as a defined risk trade. In theory, you could simply execute the offsetting contract you bought and close out the trade.
Here’s the problem – most brokers will not automatically execute the other contract on your behalf. That can create all sorts of issues in your account.
Some of what you could expect include:
- Assigned a short stock position in an IRA account that doesn’t allow for shorting
- Forced to buy stock that cuts your ability to trade the next day to zero
- Hit with assignment fees which can be hefty
Now, not everything is terrible here. When someone exercises an option, they eat all the premium left. That means you get to keep any extrinsic value that existed on that contract. Typically, you risk option assignment with near exportation sand deep-in-the-money options, reducing the amount of extrinsic value.
Dealing with option assignment
By default, I want to collapse my trades if I experience an option assignment. I never want to mess with things if it compromises my account in any way, whether it significantly reduces my margin or otherwise.
So that said, there are a few ways to deal with option assignment outside the norm.
First, you can exercise the offsetting contract. That can cost money and tends to be difficult with most brokers. It’s not a route I would recommend.
Second, if you get assigned stock, you can sell a call against that position to create a covered call. This choice works for shares in an uptrend and elevated implied volatility. You want to evaluate the opportunity the same way as if you would put on this trade from a clean slate.
Third, you can add a hedge against your position. I previously wrote about how to hedge your positions. In this case, you can use options on the stock you got assigned or similar stocks. For example, if I got assigned Facebook stock, I could buy puts on the QQQ or Google to reduce my risk.
Avoiding option assignment
In most cases, I want to just prevent option assignment altogether. There are some straightforward ways to do this.
Keep in mind, you’re most likely to get assigned a position when the short option is deep-in-the-money and close to expiration.
- Roll out spreads. This involves taking your current spread and trading it in for the same position with a further out expiration. Ideally, you want to do this as cheaply as possible.
- Roll up/down spreads. You can always move the options closer to the current stock price if there’s time left on the trade. Usually, you’ll need to pay to do this.
- Roll your spread up/down and out. Sometimes it’s best to roll prices and the expiration.
If you want to roll a spread out and up/down, you want to stick with high implied volatility environments. That way, you don’t get hit with potential rises in IV working against you. Also, you want to do this before price crosses both the strikes. Once they’re both in-the-money, it will cost you a whole lot more. Getting to it before then can even get you a bit more premium!
Learn how to structure high probability trades
One way I stay away from option assignment is by winning often. It’s not as hard as you might think.
In my upcoming webinar, I will explain how I created my TPS system with simple techniques you can use today.