When we sell a covered call option, we are undertaking an obligation for which we are well paid. Should the option holder decide to exercise that option, we must sell our shares at the specified strike price at or prior to the expiration date. This is the nature of American style options as opposed to European style options.
American style options: an option contract that may be exercised at any time between the date of purchase (sale) and the expiration date. These are the options that we, as CC writers, deal with.
European style options: an option contract that can only be exercised on the expiration date.
For the most part, share assignment will not occur until after expiration Friday when the agreed upon strike price is below the current market value. For example, if we sold the $50 strike and the current value of the stock is $52, the option holder or brokerage will exercise that option and achieve a $2 per share profit.
Why aren’t most options exercised early?
Option value consists of intrinsic + time value. Early exercise will result in the holder surrendering this time value, so it rarely occurs. The option owner may sell the call to capture the time value but early exercise and purchase of our shares does not make sense if there is significant time value remaining ($0.25 or more). It’s true that the shares can be purchased and then sold at market to capture this value but why not just sell the call? This concept applies to I-T-M and at or near-the-money strikes as O-T-M strikes would never be exercised.
How is it determined which shares are assigned if early assignment?
This is a completely random process whereby the Options Clearing Corporation (OCC) decides to which brokerage the assignment will be given and the brokerage will then pass it on to one of its clients.
Why does early assignment occur?
As time value declines (below the aforementioned $0.25), the chances of early assignment increases. There are times when the calls trade below the intrinsic value and in these cases the chances of early assignment are much greater. This will occur when the strike is deep I-T-M. Let’s look at the options chain for VIT, as an example:
Early Assignment Possible for $12.50 Call
Note that the intrinsic value of the $12.50 call is @ $3.25 (since the stock price is $15.75) and yet the bid or sale price of the option is $3.10 (red circle). Not only is there no time value for this option but it is actually trading below the intrinsic value. The $15 strike, on the other hand, has time value of $0.35 ($1.10 – $0.75). As your strike moves deeper I-T-M, the chances of early assignment increases.
Other factors that may lead to early assignment:
1- Dividends- When your equity is about to distribute a dividend, early assignment is possible for I-T-M strikes when that dividend value is greater than the time value remaining for that option. This will take place prior to the ex-dividend date or the date share ownership is required to be eligible to capture this dividend. Here is a link to a FREE site that tracks these dates:
http://www.dividendinvestor.com/tracker.php
2- High Open Interest- When you see thousands of open contracts we know that the institutional players are involved. Their trading costs are near zero and their arbitrage opportunities are greater than ours when time value approaches zero.
3- Pinning the strike- when puts and calls are near the money on expiration Friday, there is a tendancy called pinning the strike for the stock to move to the strike price or slightly beyond. This may result in assignment (not early, but unexpected) after the bell. This can also take place if there is a report or late news coming out the day of expiration.
How to avoid assignment:
1- To generate more cash (mid-contract) - If there is little or no time value remaining in our option (sold) why not unwind our position? B-T-C the call and sell the stock thereby re-capturing the time value. Now take that bundle of cash and re-invest it in another CC position. You can also roll the call out or up and out if the calculations are favorable. Remember, CC writers are tough “bosses”. No vacations or days off for our cash. They are put to work at all times during normal market conditions.
2- To avoid tax consequences- If your cost basis is much lower than the current market value of your shares, assignment may result in an unfavorable tax consequence. In these cases, you will want to close or role your calls before assignment. If your shares are unexpectedly assigned, you can purchase new shares at market and inform your broker that these new shares are to be the ones associated with the assigned option. Please check with your tax advisor and brokerage on these matters.
Conclusion:
Early assignment of your shares is rare but possible. Understanding why and when it may occur will further add to the bottom line of your investment success.
Blue Collar Updates:
1- Both of my books are now available at The Book Revue, Long Island’s largest independent book store.
2- I will be hosting a basic covered calls class on behalf of The Learning Annex on April 22nd in New York City. I will be sending out discount and other related information to all those on my mailing list.
To join my mailing list:
http://www.thebluecollarinvestor.com/joinfrnds.shtml
Last Week’s Economic News:
I don’t know which was worse: the triple digit twists and turns of the market or all that snow I had to shovel! Each time I had to clear the driveway, I considered it a workout and stayed home from the gym. Anyway, here’s what happened:
- The trade deficit rose but mainly due to increased petroleum imports. This is a possible sign of economic expansion due to increased demand.
- Retail sales rose 0.5% due to fewer layoffs and slightly increased wages.
- Business inventories fell in December by 0.2% due to increased consumer demand.
- For the week, the S&P 500 rose by 0.9% for a year-to-date return of – 3.3%.
Next Week’s Economic Reports:
- Wednesday: Minutes from the FOMC meeting, industrial production and new residential construction
- Thursday: Jobless claims, leading indicators from the Conference Board, and producer prices
- Friday: Consumer prices
Video now playing on the homepage:
The 10 Most Common Mistakes Made by CC Writers
The best in investing to one and all,
Alan
30 responses so far ↓
1 Ekann // Feb 14, 2010 at 6:47 am
thanks, great stuff. A question: Why sometimes the Open Interst move (increase or decrease) but the volume remains intact or in accord with the change in open interest?
. Example: VIT FEB 22.5 PUT, February 10, Volume = 0 and OI= 45; February 11, volume=0 and OI=11. What happens?
2 admin // Feb 14, 2010 at 9:25 am
Ekann,
For a detailed response to your question, check out this journal article I wrote a few months ago:
http://www.thebluecollarinvestor.com/blog/stock-option-chains-open-interest-and-volume/
Alan
3 Ekann // Feb 14, 2010 at 5:17 pm
Thanks. Ok I understand the point in your article but what I dont understand is how the Open Interest sometimes increase without volume or volume = cero
4 admin // Feb 14, 2010 at 6:32 pm
Ekann,
OI is a cumulative statistic. It starts from the moment the contract comes into existence and ends upon expiration Contracts bought or sold to open will add to OI; those bought or sold to close will subtract from that figure. If, at the end of a trading day, the OI is 1000, it will start the next day at that number.
Volume, on the other hand, states the # of transactions that day. So, if there are 1000 transactions at the end of the trading day on Monday, Tuesday will start with zero.
Alan
5 Ekann // Feb 15, 2010 at 8:49 am
thank you for taking the time to answer my question (I apologize for taking this space). Maybe I did not make my question clear and understandable. Anyway I will continue researching this topic. Thanks again and congratulations for this great blog
6 Brent // Feb 15, 2010 at 2:36 pm
Hi Alan,
Just read your books (great!) and new to this. With only four days left until the options expire am I right that it’s too late to look at the february options?
Thanks.
Brent
7 admin // Feb 15, 2010 at 2:42 pm
Brent,
Great to have you aboard! You are correct that it is difficult to generate a meaningful profit in 4 days. But it IS possible. With a quality watch list of 40-60 stocks you have a chance. You will first have to look for stocks trading at or near a strike price. These are the only ones that will have any meaningful time value. The disadvantage of selling an A-T-M or near-the-money strike is that there is no downside protection outside of the time value and no time for exit strategy repair.
As an example, if you sold the $55 call for VPRT at the last figures, you could generate a near 1 1/2% in 4 days.
Alan
8 admin // Feb 16, 2010 at 10:45 am
Calculations DO play a role:
Over the years, I have shown numerous examples where rolling out produced great returns with additional perks of upside potential or downside protection. Sometimes the calculations will make you walk the other way. Let’s look @ VPRT trading @ $55.26 (at the time of this post). If we previously had sold the $55 call and wanted to roll out to the March $55s, here’s how the numbers play out:
B-T-C @ $1
S-T-O @ $2.35
ROO = 235 – 1/5500 = 2.5%, 1-month return
Downside protection is negligible (26/5526)
Now the question we ask is this: Can we do better with the $5500 per contract than this? The answer in most cases is yes. If this were our decision, we would allow assignment and use the cash for another stock and call.
The calculations may become more attractive as we approach expiration Friday so we would keep an eye on it, if we still liked the stock. However, if this was Friday, most of us would probably pass.
Alan
9 Phil // Feb 16, 2010 at 6:35 pm
Alan,
In one of your past articles you mentioned beta as a factor in your choices. Just wondering how much weight you give it and when you use it.
Thanks for a great site.
Phil
10 Tony // Feb 16, 2010 at 11:07 pm
Alan,
Along with Brent (#6), I am new to investing and find your system extraordinary. Thanks for all you do for BCI-ers.
I read in some recent posts that you may be offering a premium service soon. Questions: Is this going to be the equivalent of the fundamental screens you describe in Chapter 7 of your book? Secondly, about how much will your premium service cost?
I only ask because I am a newly appointed CEO, and I am trying to determine if I should pay for the IBD Monday Special / web access subscription or wait for the BCI Premium service?
TIA,
-Tony
11 admin // Feb 17, 2010 at 7:24 am
Phil,
Beta is a significant but 2nd tier parameter. I give most credence to the equity’s fundamentals and technicals. I use beta when the market is in a confirmed trend where I favor high beta stocks if in an uptrend; low beta stocks in a downtrend.
We WILL be supplying beta statistics to all stocks on the watch list once the premium site is launched.
Alan
12 admin // Feb 17, 2010 at 7:55 am
Tony,
Welcome to the world of Blue Collar investing and thank you for your generous remarks.
My responses:
1- It will not be ESSENTIAL to retain your IBD, Monday Special membership but there is a perk to keeping it. Access to their web site will allow you to screen stocks you find on your own The $200/year cost should be covered with your first option sale. However, the watch list provided from the premium site will be the same list I use and find it more than adequate.
2- Cost will be announced with the launching of the site. I have instructed my team to keep the cost BELOW the average of other premium sites.
3- The product is so much more than the fundamental analysis as set forth in my books and DVDs. Each stock on the watch list will also be analyzed technically several times per month. Also included will be average daily trading volume and ER information. Once a stock makes it to the watch list, we provide information regarding the sector, industry, industry rank and beta. We will also show the duration the stock has made the lsit and the current status and eligibility for rolling out strategies. The product is ready, now it’s up to my web team to finish construction of the site.
Alan
13 DaveP // Feb 17, 2010 at 12:48 pm
Hi Alan,
I’m curious how your overall ROO is turning out for this option period. I wasn’t fully invested as most of the stocks on my watch list had terrible chart patterns.
Thx,
Dave
14 Barbara // Feb 17, 2010 at 3:24 pm
Alan,
I noticed that one of the stocks on my watch list, NETL, announced a stock split today. How does this effect your option decisions?
Thank you.
Barbara
15 admin // Feb 17, 2010 at 3:32 pm
Dave,
Congratulations on having the discipline to stay out when that’s what the charts were telling you. I was in cash the first part of this contract cycle as I was out of the country and unable to monitor my positions. I did re-enter for the last two weeks (conservatively) and should be able to “squeeze out” about a 1 1/2%, 2-week return. on the cash invested. A quality watch list will allow you to accomplish this most of the time.
Alan
16 admin // Feb 17, 2010 at 3:40 pm
Barbara,
I have this one too. When a company that you have interest in, announces a split the first thing I do is check the chart. If the pattern is downtrending, it may be trying to attract attention of uneducated investors. If the stock has increased in price significantly, the split is probably a positive.
In this case, NETL announced a 2-for-1 split, payable on March 20th, one day after the March contracts expire. The chart shows a big run-up since the last ER. I view this split as a positive and will be giving this stock serious consideration for the March contracts. When ready to enter make sure the chart is still positive and the calculations meet your goals.
Good catch!
Alan
17 Don B // Feb 17, 2010 at 7:16 pm
Recently I found a puzzler, to me at least. The CBOE comes up with this wonderful new system of symbols for the options, stating that the underlying symbol will be used as the first part. So what happens? WRLD (which seems btw to have wonderful technicals) shows DQX as the first three letters, not wrld. Any ideas why?
Don B
18 Dave D // Feb 18, 2010 at 8:43 am
Totally nothing to do with the stock market, but just wanted to share that my daughter was born like 5 hours ago… Her name is Serenity…
Anyway, back to the stock market… Cant wait till the new premium site is unleashed… Also, looking foward to a new contract period… Awesome…
19 Barry Bergman // Feb 18, 2010 at 9:11 am
Dave D,
Congrats!!! There is nothing better…
Barry
20 Don B // Feb 18, 2010 at 9:24 am
Hey Dave D – A big congratulation, papa. Wishing you all the best.
Don B.
21 admin // Feb 18, 2010 at 11:52 am
Dave,
That’s better than hitting a triple! A huge contrats from the entire BCI community. Thanks for sharing.
Alan
22 admin // Feb 18, 2010 at 12:05 pm
Don (comment # 17),
Because this change was a major one, it will take time for the CBOE to completely switch over to the new system. Thus far, none of the root symbols have been changed. It may appear that some have, but those are the ones that already had the same root and stock ticker.
Starting on March 12th and finishing on May 14th, these root symbols will be eliminated and you will only see the stock or ETF tickers. My feeling is that the first group will be those starting with the first letters of the alphabet.
Alan
23 Dave D // Feb 18, 2010 at 12:23 pm
Thanks Guys… I appreciate the well wishes lots…
Dave
24 Dave D // Feb 18, 2010 at 12:41 pm
Hi Alan,
With one of the trades I made (LULU) I ended up rolling down (25 strike). I was considering rolling up again (30 strike)…
2 questions…
1) Do you ever roll back up after rolling down?…
2) Is there a way to calculate this using the ESOC?
Thanks Alan
Dave
25 admin // Feb 18, 2010 at 2:46 pm
Dave,
Shouldn’t you be changing diapers or something?
Yes, I have done this in the past. After buying back an option mid-contract, my first preference would be to “hit a double”. If it appears that the stock will not rebound, I roll down to minimize losses. If the stock then rebounds after the roll down, I may roll out or out and up as an expiration Friday exit strategy. Try not to cloud the situation by factoring in the original stats that have no impact on your current decision. Here is what is important:
1- As long as the share price remains above the $25 strike, your stock value is $2500/contract.
2- To B-T-C (as of this post) your cost is $4.40
3- To roll out, we generate $4.30…we pass on that.
4- To roll out and up, we generate $0.90 and buy up the value of our shares by $4.19. Plug these last figures into the “what now” tab of the calculator to determine if you are happy with the return and upside or if youwould be better off putting the $2500 in another equity.
Alan
26 admin // Feb 19, 2010 at 3:55 am
EL:
This company is in the midst of a 4-year restructuring program to cut costs and improve the bottom line. The plan is working better than management anticipated. Revenue growth is projected to be between 9-12% for the 3rd quarter. Last ER showed earnings growth of 60% year-to-year with revenues up 11%. In addition, its industry ranks an impressive #14 amongst all IBD industries.
Alan
27 admin // Feb 20, 2010 at 6:07 am
IBD/Options:
My version of this week’s IBD 100 does NOT show the “o” adjacent to the price on the charts. I will find out why this occured and report back to you. In the interim, stocks with options can be accessed from the IBD web site as follows:
1- Go to the IBD Homepage
2- Click on “Stock Research”
3- Go to Options Center
4- Scroll down to “Stock Lists”
5- Click on “All options sorted by symbol”
Here is the direct link:
http://www.investors.com/StockResearch/OptionsCenter/reports/allstocks.aspx?reportType=2
Alan
28 admin // Feb 20, 2010 at 8:08 am
IBD update:
I spoke with the staff at IBD. They have a limited crew on Saturday but the ones there were surprised to see that options were not identified in the IBD 100 list. At this point it appears to be an oversight rather than a change in protocol.
Alan
29 Steve Q. // Feb 20, 2010 at 8:09 am
Alan:
I live in Los Angeles and my paper is also missing the option symbol. Thanks for the heads up.
30 Don B // Feb 20, 2010 at 11:34 am
Alan -
Just finished watching your “Why don’t more..” video. Very well done. A comment: I actually wrote my first option perhaps 30 years ago. Using the brokerage, he has to tell you all the details. You said this nicely, but that procedure is also clumsy. What burns me about myself, is that it took me until about 18 months ago to start again, using the internet of course. Now I am doing options continually.
I think that the online element may very well bring more into the fold. It is older guys like me that are coming around slowly, I bet. I know that I uncover, in general, ways to use the computer much more slowly than the younger ones do.
Just FWIW.
Don B
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