Thursday, February 6, 2014

Getting An Option Assignment Isn't Such A Scary Thing

Publicly-traded stocks and other equities often feature options, which are essentially derivatives of the motion of the underlying equity.  Stock options are also publicly-traded (unless you're at a company that still gives stock options as performance bonuses).  They allow individuals to reduce risk in their portfolio, or (infinitely more fun) to speculate on the movement of the underlying stock or equity.  There are two forms of options, and just like regular equities, two ways to play them.  In American-style markets, you are free to exercise options at any point prior to expiration.  I'll spare you a crash-course in options, since you can get the jist of how they work in many other places.

However, many tutorials gloss over a glaringly obvious fact that must not be intuitive to many people, based on my personal experience.  It's also extremely simple:  It is never optimal to actually exercise a call early, unless the underlying stock is about to pay a dividend.  That is, never elect to buy the underlying stock using the option at the price you selected, unless the stock is going to pay a dividend that is so big that the payout exceeds the remaining time value on the option.

The Two Faces (Values) of Options


There are two values that ultimately comprise the price of an option: its intrinsic value and its time value.  The intrinsic value is simply how "in the money" the option is, and is calculated by the difference between the option's strike price and the actual stock price at that very moment.  Upon expiration, the only value left in an option is its intrinsic value.  The time value, on the other hand, is based on a calculation of how much the stock would reasonably move given the amount of time left until expiration and its past history of volatility.  Thus, volatile stocks always carry hefty time premiums, but my little ol' NMM stock doesn't tend to carry rich option valuations.

It's this bit of time premium that you will never be able to capture if you simply exercise the option.  You are better off selling the option and making a few dollars more than if you exercised the option and immediately liquidated your position.  Plus, in the real world, it's probably far cheaper to pay the commission to sell the option than it is to pay the commission to exercise the option and then pay yet more commission to liquidate the position you just incurred from exercising the option.  For instance, it would be $20 or $25 to exercise and liquidate with my broker (I've never actually done it :-P), but only $2.95 to sell the option itself.  Here's another extreme example: let's say you just bought (for real cheap) the right to buy the VXX at $53 when it is still at $49, because you're expecting the market at large to take a dump.  The stock indeed pops to $52, and so the options premiums skyrocket, even on the $53 call, which still doesn't have any intrinsic value but is now carrying an epic time value of $1.50 (thus pricing the VXX at $54.50).  You would still be foolish to exercise the $53 call; why buy the stock at $53 when it's selling at $52 on the market, and when you could just sell the option as if the stock were at $54.50?

(Note from the School of Reality: Only the VXX and biotech firms reliably behave like this.  Most of the time, when a stock pops or drops big, it's the result of an earnings announcement.  In this case, any options that are still out of the money after the market has reacted to that announcement essentially become worthless, as it's unlikely the stock will incur any additional movement.  However, as a result, it can still be fun to gamble on a 1-2% swing on the day after earnings are announced, as I've actually recovered completely from incorrect directional bets on the actual earnings report doing this myself.)

So What?


The reason I write about this today is that on this very day, according to my records, someone actually assigned a call to me!  Properly!  For the first time ever!  I've been assigned on various options I've sold against NMM three times in the last three years, including today.  Prior to my easily-accessible records, I may have been "called away" on NMM before, and I've certainly been called away on other holdings like ELN.  It's worthwhile to me to hedge the risk when the stock drops, though usually what happens is I hang on to that short call position a little bit too long and they snag it from me at a "discount" before I get a chance to buy the option back for cheaper.  Thus, this is definitely not my first time to the assignment rodeo.  (Though I can say I've never shown up "naked" to that rodeo. :-P -- that is, not owning the underlying stock at the time someone wants to buy it from me.)

Usually what happens is some nitwit decides to exercise the call option early in order to purchase the stock at a nice discount from its market price, not realizing they'd be better off simply selling the option.  Based on what I can tell, prior to today, I was never assigned on an NMM option on the ex-dividend date (the last day on which you can put in an order to buy the stock and collect its dividend), so I'm not sure what those other two fools who exercised early were doing -- obviously not trying to capture a dividend.  ELN never paid a dividend the whole time I owned them, so I was shocked to ever see any kind of assignment notice on that position.  We must have fourth-graders trying to play options out there.  If I'm going to be called away on a position, it's refreshing to at least see it done right and correctly thought-out!

How I Made Money Off The Assignment


Nevertheless, seeing the assignment notice was definitely a suitable substitute for coffee for me this morning.  I had other short options in my portfolio on the VXX and on UNG.  I was afraid someone picked one of those to exercise, and I definitely don't have enough money to cover those.  Luckily, either people are too smart to exercise those early, or the system always assigns early exercises to those who actually own the underlying, so I was relieved to see an extra $1,750.00 in my account from the sale of NMM.  I knew what I needed to do then; find out if today is the ex-dividend date (it is), and then re-purchase the 100 shares for myself so I too can capture the dividend.  This is where it gets amusing; I'm pretty sure every time I've been assigned, I've always made money off the assignment.  If I buy the option back, OTOH, I'm historically more likely to lose money.  I originally sold the $17.50 call for 80 cents, less a $2.95 commission.  Then, the assignment fee was $14.99, IIRC.  It cost $5 to buy back the 100 shares at a price of $18.03/share.  All in all, I made about $4 from the exercise, after commission. :-P  That made me feel a lot better about being assigned!  At least I didn't lose any money on the hedge.

Post-Mortem


I should have known February would have the ex-dividend date.  After all, it was in February 2011 that I bought NMM in the first place in order to capture their insane 9% dividend yield.  It dipped briefly in the interim, only increasing the dividend yield.  The stock is, to this day, a bit beneath what I bought it at originally, but I've made quite a nice double-digit return on it since I bought it anyway.

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