Options Debit Spreads?

Question

I was wondering when it comes to option debit spreads...is exercise a likely occurence? I am a fan of credit spreads because I get the money upfront, but I want to have every weapon possible when it comes to trading. I am looking for trader's opinions. The only thing I am worried about with debit spreads is exercise...should I be and what is the best way to make profits while reducing the probability of exercise? Thank you all very much.

Answer 1

There are a couple of points that need to be cleared up before getting to the answer to the question.

First, the ability to "exercise" an option only exists with a long option position. When a long option position is exercised, a short option position is assigned. What is possible, and not under your control, is early assgnment.

Second, the likelihood of assignment has nothing to do with the option being part of any kind of spread, debit or credit. If a stock is at $50 early assignment is more likely with a (long $50/short $55) put credit spread than with a (long $50/short $55) call debit spread.

It is a given that for an American-style settlement option assignment can occur any time. There have even been instances where there have been assignments on out-of-the-money options, although you are unlikely to ever see it. Consequently, I would recommend you avoid any short option positions where early assignment would cause you difficulties.

The real question becomes "when is early exercise likely?"

For a call option, the only time a knowledeable option trader "should" exercise a long option position early is just before a stock goes ex-dividend and the dividend exceeds the amount the option price will decrease when the stock goes ex-dividend. (If you are familiar with "the greeks" you can use delta to make this determination, otherwise just understand that the larger the dividend, and the closer to expiration, the better it is to exercise the call option early.) As a call option writer, that means the only time you are likely to see early assignment is when the stock goes ex-dividend with a substantial dividend. It the stock does not pay dividends you are quite unlikely to receive an early assignment.

If you write a put option, dividends are not a significant factor in determining if you are likely to receive an early assignment. Instead, simply took at the current bid quote of the option. If the bid quote is less than the intrinsic value of the option, there is a realistic chance that you will receive an early assignment.

I recognize that depending on your options knowledge this answer might be difficult to follow. Other people have asked about the risk of early assigment on the Yahoo message boards at

http://messages.yahoo.com/Business_%26_Finance/Investments/forumview?bn=4686677

and

http://messages.yahoo.com/Business_%26_Finance/Investments/forumview?bn=4686677%23optionsquestionsansweredhere

so if you want to find other answers to the same question you can go to those boards and use the search function to look for "early assignment".

Answer 2

<<>> Vertical Spreads: Assume a stock is trading at $50 and I do not think the stock price will move significantly before expiration. I also believe implied volatility is too high. To capitalize on the situation I want to open a bullish vertical spread using $45 and $50 strike prices. I can open do this two ways. I can use a put credit spread, selling the $50 put and buying the $45 put, or I can use a call debit spread, selling the $50 call and buying the $45 call. If I sell the put spread, I will receive $2.10 per share when I open the spread. If I buy the call spread, I will pay $2.65 per share when I open the spread. My maximum profit from the put spread is $2.10 per share. My maximum loss fron the put spread is $5.00 - $2.10 = $2.90 per share. My maximum profit from the call spread is $5.00 - $2.65 = $2.35 per share. My maximum loss from the call spread is $2.35 per share. I would prefer the call debit spread to the put credit spread in this example. Of course, it is equally possible that I could receive $2.35 for the put credit spread and have to pay $2.90 for the call debit spread, in which case I would prefer the credit spread to the debit spread. Calendar (horizontal) spread <<>> If you buy a calendar spread when implied volatility is too low there is a good chance that you will be able to sell the back month option for more than you paid for it, possibly giving you a profit on both legs of the spread. Even if both IV and the stock price remain constant until the front month expires the spread should be profitable since theta (time decay) will have had more of an implact on the front month than the back month. <<>> You do not have a guaranteed negative transaction because the back month option can increase in value due to changes in the stock price and the implied volatility. <<>> One thing you do not seem to be taking into account for either the vertical or calendar spreads is the impact of a change in implied volatility prior to expiration. A change in IV will have a bigger impact on the ATM option (in a vertical spread) and the back month option (in a calendar spread). In a vertical spread you want to buy the ATM option if you think IV is going to increase, and you want to sell the ATM option if you think IV is going to decrease. Similarly, you only want to open a standard calendar spread when you expect IV to increase. Option trading is more about volatility than the direction the stock price will go. In general it is better to take a stock position (long or short) than an options position unless you think implied volatility is too high or you think implied volatility is too low.

Answer 3

As long as the price of the underlying is above the strike of the long options in the spread, you're okay. If you're close to expiration, buy the shorts back and sell the longs.

When you get into trouble is when the price of the stock is above the strike of the short options, but BELOW the strike of the longs. If you're close to expiration, close the spread for a loss to avoid exercise.