What happens when one leg of a spread is exercised?
First off , happy thanksgiving to everyone!
Second, I have a bit of a beginners question. What happens if the short leg of a vertical spread is exercised? I am relatively new to options and have primarily bought naked calls and puts. This week I bought a vertical spread though. I am long AAPL February 535/540 call spread. AAPL is above 550 now. So am I incorrect in assuming that I am at risk for an early assignment on the short leg? If so, what happens? Am I left with a long call and short 100 shares of AAPL? If so, how would I close everything out to be totally flat on it?
Hope you had a good Thanksgiving as well.
Technically whenever one is short an option there is a risk of assignment. Sometimes that risk is very high, but rarely will it result in financial loss. Let me give you an example of an "at risk" position I experienced last year.
I had purchased a JNJ 70-75 bull call spread expiring about 40 days out. The stock ran up in price well above 75. My short 75 options had about 10 cents of extrinsic value and the stock was soon going ex-dividend for 60 cents. Since the dividend was more than the intrinsic value, I knew I had a high probability of being assigned. If I had been assigned, I would have been long the 70 calls and short the stock which I had to sell at 75. As the stock continued to go up, I would be losing money on the short stock, but I was completely hedged by the 70 calls that I could exercise at any time. Being hedged wasn't my concern, being short the stock when it went ex dividend was. Short sellers are charged the dividends, and i didn't want that to happen.
In the case of Apple the stock recently went ex-dividend, so there is no dividend to worry about at this time. The questions are 1) are you at risk if you get assigned and 2) how high is that risk. As to the first question, since you have a spread, if you are assigned the shares but are long sufficient contracts to cover the assignment, you have no risk, your position is 100% hedged: if the stock goes up, you are protected by the long calls; if the stock goes down, you are short the stock. As to the second question, how high is the risk of being assigned? The options you are short currently have quite a bit of extrinsic value. The Dec 540 calls are going for about $22. The 540 plus 22 is 562, and with the stock at 556 they have about $6 in extrinsic value. Why would someone exercise an option worth 562 to buy a stock trading at 556? It would make more sense for them to sell their option for the 22 and buy the stock for 556.
Hope this helps allay your concerns about assignment.
Last edited by HeartMan; November 30th, 2013 at 02:04 PM.
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If the 540 call reaches the point where it becomes a candidate for early exercise and you are assigned the short stock then the 535 call will be even more of a candidate for exercise and you simply need to do so. The long shares from your 535 call will cancel out the short shares from the 540 assignment.
So if Apple is trading at 570 and I am assigned on the 540 I wind up short 100 shares of AAPL at 540.
I can then exercise my 535 option and get 100 shares of apple at 535.
This flattens me on the security as well as the option.
Does this mean I made a profit of $5 a share?