The Risk of Early Exercise

Selling OEX options comes with Extra Risk

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The owner of an American-style option has the right to exercise his/her option at any time -- before it expires. The owner of a  can exercise only when expiration arrives.

This represents a bonus for European option sellers because he/she never has to worry about being assigned an early exercise notice.

When trading equity options, receiving a notice is no big deal (unless it results in a  margin call).

However, early exercise represents significant risk when dealing with American-style, cash-settled index options. Fortunately, there is only one such beast: Options on the S&P 100 Index (symbol: OEX).

Clarification: This warning applies only to OEX options. 

Example

Assume that you sell two OEX Dec 850 puts (naked) and that your timing is unfortunate. The market declines for several days and falls especially hard one afternoon. OEX closes at 835, the low price of the day. Let’s ignore why you may still be holding this position (prudent risk management suggests that this position should have been closed or adjusted well before you find yourself in this situation).

Immediately after the close, AAPL (or IBM or GOOG) announces spectacular earnings and SPX futures trade much higher. Translation: The market is likely to gap much higher at the opening tomorrow morning.

That should be wonderful news for your position because the anticipated rally means that you will recover some of the current loss.

With OEX at 835, the Dec 850 puts have 15 points of intrinsic value and are worth at least $15. When you look at the current market quote at 4:05 pm ET, after the bullish news has been announced, (these options trade until 4:15 pm) you are surprised to see that the options with $15 intrinsic value are offered well below $15.

The bid/ask market is very wide: $10.25 bid// $15.00 ask.

This seems to be impossible. It appears to defy logic. But, not to the experienced OEX trader. The person who owns your puts sees the very low bid price. He/she heard the very bullish news and knows that it will be impossible to sell the out options near $15 right now ($10.25 bid) or tomorrow. So what does that trader do? 

The trader exercises the puts, thereby selling them at the current intrinsic value, or $15 ($1,500 per option).

How does that affect you, the option seller? 

The next morning, before the market opens, two things happen:

  •  Futures indicate that the Dow Jones Industrial Average will open  200 points higher.
  • You are notified that you were assigned an exercise notice on two OEX Dec 850 puts. These options are cash settled, based on yesterday’s closing OEX price. Thus, you were obligated to buy those options, paying $1,500 apiece.

Sure enough, the markets open strongly higher and OEX Dec 850 puts trade at $9.50, or 5.50 points lower than last night’s intrinsic value. But for you, it is too late. You were forced out of the position and paid $15 to cover your short position.

This is a very real situation and it happens to naive OEX traders.

When it appears that the market is about to change direction immediately because of news, it is common for deep ITM option owners to exercise. That eliminates overnight risk and allows the sale of options at current intrinsic value. NOTE: The OEX closing price has been determined. The options may trade for another 15 minutes, but the day's settlement price is already known to be $15.00. 

Many traders who are short these deep in-the-money OEX options find that they have been assigned an exercise notice -- with that notice arriving the following morning, before the market opens. NOTE: Some traders escape this fate because there are always unsophisticated option owners who were not aware of last night's news. Nor would they have known what to do had they been aware. Do not depend on being lucky.

It is best to avoid this situation by not being short any OEX options. Trade one of the other indexes instead, if you like to trade spread positions.  

If you ask: Why exercise? Shouldn't the option owner sell the options? Sure, but the question is: who’s going to buy them? The put bids disappeared as soon as news hit and options were bid far under intrinsic value. The only way to collect $15 for the Dec 850 put option (in this example) is to exercise.

Put spread

If you think the loss just described is bad, imagine how much worse it is when you own long puts as a hedge against the short puts, and fail to exercise your long puts. Not only would you repurchase your shorts at the worst possible time (because of the assignment notice), but you now have additional losses because you still own the (now naked long) other puts that was part of the original spread. When the market opens for trading, these puts will be priced well below last night's closing value.

Thus, you lost money on each option in the spread. When we own hedged positions, this result is supposed to be impossible. After all, the hedge is put in place to reduce losses. The hedge does work as planned -- except when you cover one side of the spread (involuntarily) and hold onto the other.

Any trader who sells options as part of a strategy should avoid trading OEX in favor of one of the European-style index options. This is not just advice. It is mandatory. 

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.