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Preventing a Suicidal Exit to a Short Call Spread

Options Trading TradeKing

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Mark Wolfinger reviews the choices a spread trader faces upon expiration / assignment

Warning: today's post isn't the shortest, but I wanted to give this trader a comprehensive response to the questions posed (which are themselves not too simple). If you're new to options and particularly to spreads, I'd urge you to follow along. This Q&A illuminates some critical gaps you'll want to make sure are filled before you trade with real money.

BrownBear wrote in the TK forums

For a short call spread, lets say in the case of AAPL, I bought the $370 calls and sold the $365 calls.  Obviously it would be a ideal for both calls to expire worthless and just keep the premium.  But what if you do NOT buy the short calls back before expiration, and the stock closes at $365.03.  Does this mean I lose all the margin I put up for the trade?  Or will they just take the difference of the closing price and the short call?  


So if I had 5 contracts on this trade, will it cost me $2,500.00  (500 x (370-365)) ?

OR

will it cost me $15.00  (500 x (365.03 - 365))

I understand the mechanics that I upon assignment I am required to sell 500 shares at $365.00, but I'm unsure if brokers go out and buy the shares at current market price then sell, or if they would use the price of the OTM call that I bought.

If someone could help me out I would greatly appreciate it.

Hello BB,

I hope you'll take these comments as an effort to help you understand what you are trying to do, and not as a criticism. Understanding the basics must come first. Finer points cannot be ignored, but if you do not understand the basic idea of how option trading works, then the finer points will not make sense to you. Language of options is important, and subtle changes can alter the meaning of what you are trying to say.

Your chosen strategy, the short call spread, is designed for those with a non-bullish bias. You don’t have to see the stock decline to earn a profit. What the call seller needs for success is for the stock not to rise as far as the strike price of the options sold (AAPL, $365 in your example).

Your maximum potential profit is the cash collected when selling this spread. (Don't forget to subtract TradeKing's commission of $10.45 for a 5x5 spread.) You neglected to mention that important number, but please know that you can never earn more than that amount.

What’s the trade's risk? If AAPL does rise and moves beyond $370 (the strike of the option you own) when expiration arrives, then the spread reaches its maximum possible value. That value is the difference between the strikes ($5 in your example) x 100. Your loss is that maximum value, minus the cash collected for each spread. If you traded five call spreads, then you lose that amount, multiplied by five.

It is apparent you don't know what happens when expiration arrives. Unfortunately, none of your guesses are correct. That’s a shame because exercise and assignment at expiration are among the most fundamental concepts of options trading.

When you sell a call option on a specific stock, if that option is in the money (stock above strike price) when expiration arrives, you will be assigned an exercise notice and become obligated to sell 100 shares of that stock for each call option. This is not a choice; this is a fact that's nearly certain to come true in the circumstances outlined above. The obligation to deliver shares to the call owner is part of the option contract.

That is what happens at expiration, and you understand that part. However, there is no one to fix your problems. No one buys the stock. No one takes the cash difference. The ONLY thing that happens is that you SELL the shares.

To prevent the consequences of this obligation (including a potentially huge margin call you cannot meet), you MUST repurchase the calls that you are short before the market closes for trading on expiration Friday. The only exception occurs when the calls you own (AAPL 370) are also in the money. Then you can simply exercise the calls you own, eliminating any stock position. But it does lock in the maximum possible loss, and it is too late to do anything about that.

When assigned, if you do not already own the shares, they will be sold for you to create a short position. When you see your account on Monday (or Sunday) following expiration, it will be short 500 shares (in this case) of AAPL. Believe me when I tell you that there is substantial risk when owning a short position this large. That is why TradeKing, or any broker, will do its best not to allow you to incur such risk or create that margin call. But the final responsibility is yours.

You do not "lose all the margin". The margin requirement is the cash that you must have in your account before you have permission to place the trade. Margin is required to be certain that you can cover losses, should they occur. For credit spreads, the margin requirement usually equals your maximum possible loss, but that will not always be the case.

When expiration arrives,  there is no "they" who will take the difference in cash. That situation applies ONLY for CASH-SETTLED options, and not for options on stocks.

I get how anxious you are to enter the options fray, but please know what you are doing first – ask questions now and trade only when confident that you understand the rules. Traders do blow up their accounts with simple errors – and not knowing what happens when you are assigned an exercise notice is an unforgivable trading sin. I'm just glad you're trying to understand now, before expiration arrives.

In your scenario (AAPL $365.03), the long calls expire worthless and you do not lose $2,500. In fact, you would have a nice profit – if you would only do the sensible thing. What is that? It is BUYING back those AAPL 365 calls before expiration. It can be done as late as expiration Friday, but it must be done if the options finish ITM.

In fact, it SHOULD be done even if the option is out of the money. The final trade of the day could push the stock beyond the strike price, and by the time you see that final, closing price, it would be too late to buy back those calls. That would result in the margin call mentioned above and could be quite a disaster for you (imagine AAPL gapping higher by 20 points on Monday morning – and that could be the price at which you would be forced to buy those shares.)

If uncertain as to whether the stock will be above or below the strike at the closing bell, you must buy those options to prevent a disaster. If you do not buy them, you will be assigned an exercise notice (your scenario has them finishing three cents ITM) and be short 500 shares of AAPL @ $365 per share. That is $182,500 worth of stock. You know you cannot meet the margin call, so why in the world would you want to refuse to buy back an inexpensive option?

That would be beyond foolish. Insanity is a better description. But now that you are aware of all of this, I'm sure you won't allow this to occur. 

To protect traders from committing this type of suicide, TradeKing will not allow you to "refuse". They will give you a time limit for buying the calls that you are short – if they are in the money. I’m sure that you would prefer to time the purchase of those calls yourself – but when you cannot meet the margin call, TK is doing you a favor by preventing you from being assigned an exercise notice on 500 shares of AAPL.

To summarize:Yes, you must sell the shares if assigned. But:

  • No one "goes out" and buys the shares for you
  • If assigned an exercise notice YOU sell the shares at the strike price
  • If you do not own the shares, then they are sold short, exposing you to theoretically unlimited losses
  • The cash premium that you collected when selling the call is 100% immaterial in that case
  • How far ITM is 100% immaterial

BB, this is vital information that must be understood before you make your first trade, not after. People can and do lose many thousands of dollars by not learning this info in advance. It's not complicated, but it is crucial. 

I understand that there are situations in which a new trader does not know what exactly he or she doesn't know. In this case, you assumed that someone would be there to take care of the stock position – but it turns out you are on your own. 

Regards,


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