Anticipating Assignment
From: McMillan, Lawrence G.,Options as a Strategic Investment, pp.18-20, p.22, New York Institute of Finance, NY, NY, 1980.
The writer of a call often prefers to buy the option back in the secondary market. rather than fulfill the obligation via a stock transaction. [snip] The writer who is aware of the circumstances that generally cause the holders to exercise can anticipate assignment with a fair amount of certainty. In anticipation of the assignment, the writer can then close the contract in the secondary market. As long as the writer covers the position any time during a trading day, he cannot be assigned on that option. Assignment notices are determined on open positions as of the close of the trading each day. The crucial question then becomes, "How can the writer anticipate assignment?" Several circumstances signal assignments:
1. a call that is in-the-money at expiration [will be automatically exercised],
2. an option trading at a discount prior to expiration, and
3. the underlying stock paying a large dividend and about to go exdividend.
1. Automatic Exercise
Assignment is all but certain if the stock is in-the-money at expiration. Assignment is nearly inevitable even if a call is only 1/8 of a point in-the-money at expiration. [snip]
2. Early Exercise Due to Discount
When options are exercised prior to expiration, this is called early, or premature exercise. The writer can usually expect and early exercise when the call is trading at or below parity. A parity or discount situation in advance of expiration may mean that an early exercise is forthcoming, even if the discount is slight. A writer who does not want to deliver stock should buy back the option prior to expiration if the option is apparently going to trade at a discount to parity. The reason is that arbitrageurs (floor traders of member firm traders who pay only minimal commissions) can take advantage of discount situations.
Example:
XYZ is bid at $50 a share. and an XYZ January 40 call option is offered at a discount price of 9 3/4. The call is actually "worth" 10 points. The arbitrager can take advantage of this situation through the following actions, all in the same day:
1. Buy the Jan 40 call
2. Sell short XYZ common stock at 50
3. Exercise the call to buy XYZ at 40.
The arbitrageur makes 10 points from the short sale of XYZ from which he deducts the 9 3/4 points he paid for the call. Thus his total gain is a quarter point -- the amount of the discount. Since he pays only a minimal commission, this transaction results in a net profit.
Also, if the writer can expect assignment when the option has no time value premium left in it, then conversely the option will usually not be called if time premium is left in it.
Example:
Prior to the expiration date XYZ is trading at 50 1/2, and the Jan 50 call is trading at 1. The call is not necessarily in imminent danger of being called, since it still has half a point of time premium left.
TimeValuePremium = CallPrice + StrikePrice - StockPrice
TimeValuePremium = 1 + 50 - 50 1/2
TimeValuePremium = 1/2
3. Early Exercise Due to Dividends on the Underlying Stock
[end of quotation]
[quote from p.22]
Of course, the anticipation of an early exercise assumes rational behavior on the part of the call holder. If time premium is left in the call, the holder is always better off financially to sell that call in the secondary market rather than to exercise it. [snip] Though not often, financially unsound early exercises do happen, and the option writer must realize that, in a very small percentage of cases, he could be assigned under very illogical circumstances.
[end of quote] |
