0

Context

  • I have no background in Finance but I have many years experience in investing in equities for my personal portfolio so I have a basic understanding
  • I have never traded options
  • I'm keen to understand and learn about options trading for some time before I try with real money (I'm mainly learning via youtube videos and TOS paper trading, which doesn't simulate assignments)

Example Scenario

GIVEN:

  • I do not own any stock in the company that I am buying the options against
  • I sell a single naked call at $150 (short)
  • I buy a single naked call at $151 (long) for the same expiry date
  • For this vertical spread I received a net credit of $50
  • The stock price is $160 at expiry, with my call spread in the money
  • I have less than $15,000 cash in my brokerage account
  • I have less than $15,000 margin available
  • I have no existing stock positions that the broker could liquidate

WHEN:

  • My broker automatically assigns me on the short call and I am therefore required to sell 100 shares at $150

THEN:

  • I would have to first buy 100 shares at $160 (at a cost of $16,000) in order to sell them.
  • After selling the shares to fulfil my short call assignment, I will receive $15,000
  • The outcome of the trade would be a loss: $50 credit received - (($10: $160 stock price - $150 short call strike price) * 100) - fees ≥ $950 loss

OR:

  • I have the option (i.e. I could exercise my long option) to buy 100 shares at $151 (at a cost of $15,100), which would reduce my loss.
  • After selling the shares to fulfil my short call assignment, I will receive $15,000
  • The outcome of the trade would be a net profit: $50 credit received - (($1: $151 long call strike price - $150 short call strike price) * 100) - fees ≥ $50 loss

Obviously, the 2nd outcome is preferred.

Questions

  1. Is the broker going to allow me to make this trade given the risks?
  2. Would the broker allow me to exercise the long call, given I neither have the cash nor the margin, but I do have the impending income from the short call?
  3. Would the broker automatically exercise the long put on my behalf and then liquidate them to fulfil the short call assignment?

Thanks!

  • How are you getting a $300 credit for a $1 wide vertical spread? – Bob Baerker Mar 13 at 13:10
  • Edited. This is just an example, and the credit received is not relevant to the questions. – Darryl Snow Mar 13 at 13:18
  • 1
    If you set up an inaccurate example, the part of the answer relating to P&L becomes inaccurate. – Bob Baerker Mar 13 at 13:26
  • I don't think I'm asking about P&L but if P&L bears some significance in the answers to my questions then I'd love to see those answers. – Darryl Snow Mar 13 at 13:36
  • 1
    If you're not asking about P&L then why are you including several sentences in your question that involve the calculation of P&L? – Bob Baerker Mar 13 at 14:27
3

First, a small terminology correction. You don't buy a naked call. That's an outdated form of description from decades ago. A naked call is a short call that is not covered by long stock or a long call.

Your broker allows such trades because the margin requirement (the risk) is the difference in strikes less the premium received.

My broker automatically assigns me on the short call and I am therefore required to sell 100 shares at $150 then I would have to first buy 100 shares at $160 (at a cost of $16,000) in order to sell them. After selling the shares to fulfil my short call assignment, I will receive $15,000 . The outcome of the trade would be a loss: $50 credit received - (($10: $160 stock price - $150 short call strike price) * 100) - fees ≥ $950 loss

The OCC exercises all options that are one cent ITM at expiration so if you have the margin to carry the trade then you would not have to do anything. The exception to this is if you own an ITM option and you designate to the OCC via your broker not to exercise (not applicable here).

If you are assigned prior to expiration and if you have a margin account along with 50% margin (cash or other marginable securities) to support the short position then your broker will borrow the shares from another account or another broker and you will sell 100 shares at $150. $15k will be deposited to your account and you will pay a daily borrow cost.

You own the $151 call and at $160 it will be worth at least $9. If you choose to exercise it, you'll but the stock for $151, realizing a $1 loss on the stock. Since you received an initial credit of 50 cents for selling the spread, you'll have a 50 cent loss ($50).

Where this gets tricky is if you lack the margin to support the assignment. What will happen will depend on how your broker handles this. When assigned on the short $150 call, some brokers will then exercise your long call. I have read that in a similar situation on expiration day, Robinhood will close ITM positions an hour or so before expiration. In this case, no harm, no foul but in where you have put protected long stock or call protected short stock, it opens one to directional exposure post option close out. The short answer is that you should contact your broker and find out how it handles such situations.

| improve this answer | |
1

The broker will let you make this trade, although probably not allow you to sell the 151 call after you buy the spread. The systems are smart enough to know that the 151 call is protecting you from infinite potential losses.

You should never need to "exercise" this spread, or be forced to buy any stock. Just close out the spread on expiration day or sooner. If the price is under 150 just let them both expire worthless and you just collect the original premium.

| improve this answer | |
  • 1
    It's good practice to close any short positions at expiration that are near and slightly out-of-the-money because there's a small chance that news hits at the last moment and the options are propelled ITM. – Bob Baerker Mar 30 at 10:52
  • @BobBaerker true good point – Chris M Mar 30 at 13:16

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.