Option Basics: Early Assignment Risk on OEX (5:15)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 5, No. 15 on August 8, 1996

Most stock options and a few index options are American style, meaning that they can be exercised at any time during their life. Most index options are not American style, but are European style, meaning they can only be exercised on the day they expire. Large institutions — many of whom sell index and sector options to hedge portions of their portfolios — prefer European style exercise because they then know they can't be called out of short positions prematurely. However, OEX options have always been American style. This makes them more interesting, but it means that one has to be on his toes when he is trading spreads in OEX — either debit spreads or credit spreads — if short options in the spread become deeply in-the-money.

In our examples, we'll use put credit spreads because that is what got a number of traders in deep water last month. Suppose that the following prices exist:In our examples, we'll use put credit spreads because that is what got a number of traders in deep water last month. Suppose that the following prices exist:

Presumably, the trader who has this credit spread in position sold it when OEX was much higher and both puts were at that time out-of-the-money. Now, with OEX at 610, at face value, the spreader merely has a riskless position: both options are well in-the-money and completely hedge each other. They are trading at a differential of 10 points — the maximum loss that can theoretically occur because the strike prices of the two puts are 10 points apart.

Early assignment can bring a nasty surprise, however. Suppose that the trader comes into work on July 12th and finds that all 10 of his short OEX 640 puts have been assigned. When an OEX option is assigned, it is a cash transaction. His account would be debited $30,000 (10 puts at a cost of 30 points at $100 per point). But what remains is his 10 long OEX 630 puts — a completely unhedged and very bearish position. Suppose that the market has a big rally the next day. He would suffer further losses at the rate of $1000 per point that OEX rises (since he's long 10 puts). Thus, if OEX were to rally to 615, his July 630 puts would only be worth 15, so if he sold them then in the open market, he would receive $15,000 (less commissions). In sum, then, he would have exited his spread at a cost of $15,000 (the $30,000 debit from the assignment less the $15,000 that he received from selling his long puts in the open market). Alternatively stated, he would have exited his 10-point spread at a cost of 15 points!

So, before you trade credit or debit spreads in OEX options, you must realize that your risk can be greater than the difference in the strikes, due to early assignment. Of course, it's possible that the market could have dropped after the trader in the above example received his early assignment. However, it's not likely (as we'll explain in a minute) and besides, the early assignment transformed him from a trader with essentially no market risk (he was long and short two deeply in-the-money puts) to one with extreme market risk. Few traders change their market position that dramatically by choice, so the early assignment is not a friendly happenstance even if it should luckily work out to his advantage.

Early Assignment Can Affect The Entire Market

We stated that it wasn't likely that the market would drop after the trader received his early put assignment. Here's why. When a large number of puts are exercised on a given night (July 11th in our example), a whole bunch of traders arrive at work on July 12th to find out that they are now long a lot of unhedged puts, just like our trader in the example. That is, these fellows realize they are extremely short the market. Since they had no market exposure the day before, it's a good assumption that they don't want this newly-acquired market exposure, so they will do something to get rid of it. Well, if you're extremely short the market (i.e., you're long OEX puts), what can you do to hedge yourself? Buy something! Thus, the next morning these traders will buy S&P futures and OEX stocks in order to hedge themselves. Their actions will make the market go up. A large early exercise of OEX puts will make the market rally on the opening the next day; similarly, a large early exercise of OEX calls will make the market fall on the opening the next day. You might think that these traders are hurting themselves by buying on the opening (because they are causing the puts which they are long to decrease in value). In the short run, they are hurting themselves, but they will lose a little money to re-establish a hedged position for they don't want as much market risk as they acquired via the early assignment of their short puts. In the previous example, our small trader who was long 10 puts gets hurt by the market rally on the morning of the 12th. Another important point: After the initial market movement caused by traders hedging off their risk acquired after the assignment, the market often trades back in the opposite direction.

In fact, these actions are exactly what occurred last month. On July 11th, after the S&P futures were down 13.40 on the close, there was a large OEX put exercise. Thus, on July 12th, the S&Ps gapped opened 1.70 higher and traded up another 2.50 before peaking and falling 9 points the rest of the day. The moves on July 15th-16th were even bigger. The S&Ps closed down 17.80 on July 15th. After the close, another large OEX put exercise took place. On the 16th, the market gapped open 1.80 higher, traded up another 1.50 as some traders hedged their long put positions, and then proceeded to collapse over 20 points from that high!

How can one determine if he is at risk of early assignment? The same way that always works for all kinds of options — stock, index, or futures: when there is no longer any time value premium in the option, then there is a large risk of early assignment. Thus, if you have sold a credit spread and both sides are deeply in-the-money, it is best to cover the spread in the open market (at a differential approximate-ly equal to the differences in the strikes in the spread) rather than suffer the ramifications of early assignment.

Conclusion: When a large early assignment of OEX options occurs, it has meaning for all traders. First the market will move at the opening (up after a put exercise or down after a call exercise), but then the market often reverses and heads back the other way. This reversal is especially likely if there is a true market trend in force (as there was last week). Thus, OEX and S&P day traders can use this information to their advantage, even if they're not directly involved with the early assignment in their own positions.

This article was originally published in The Option Strategist Newsletter Volume 5, No. 15 on August 8, 1996.