In the video titled “Short Put Assignment – How to Avoid It & What to Do If Assigned” by Options with Davis, you will learn valuable information on how to handle the concern of short put assignment. When you are assigned, it means you are obligated to buy the underlying shares, which can result in a margin call if you don’t have the necessary funds. The video provides timestamps for easy navigation and covers topics such as understanding put buyers, avoiding assignment, and what to do if you are assigned early. By watching this video, you will gain valuable insights and strategies to help you navigate the world of put options and option trading as a beginner.
In the video, Davis emphasizes the importance of understanding the methods to avoid early assignment, including the defensive method and the extrinsic value preservation method. He also discusses scenarios for exercising put options and when it may not be the best option. By following his advice and recommendations, you can better manage the risks associated with short put assignment and make more informed decisions in your option trading journey. So, if you want to learn how to avoid getting assigned on a short put and how to handle the situation if you are assigned, this video is a must-watch!
Short Put Assignment
Short Put Assignment is a concern for many investors who engage in options trading. Being assigned means being obligated to buy the underlying shares at a specific price, which can lead to financial implications if the investor does not have the funds to fulfill the obligation. In this article, we will explore the risks of assignment, the effects of a margin call, and provide strategies on how to avoid being assigned.
Understanding Short Put Assignment
When a short put option is assigned, it means that the investor is required to purchase 100 shares of the underlying stock at the strike price of the option. This can happen when the option is in the money, meaning the stock’s price is below the strike price of the put option.
Risks of Assignment
The main risk of assignment is the financial obligation it creates for the investor. If the investor does not have sufficient funds to purchase the underlying shares, they may receive a margin call from their broker. A margin call requires the investor to deposit additional funds into their account to cover the cost of purchasing the shares. Failure to meet the margin call could result in the forced liquidation of other positions in the investor’s account.
Effects of Margin Call
A margin call can have significant implications for the investor. In order to meet the margin requirements, the investor may be forced to sell the 100 shares they were obligated to purchase. This can result in a loss if the stock price has decreased since the assignment. Additionally, the investor may be required to sell another put option at the same strike price but with a longer expiration date in order to fulfill their obligation.
How to Avoid Short Put Assignment
There are several strategies that investors can employ to avoid being assigned on their short put options.
Understanding Put Buyers
To avoid assignment, it is important to understand the mindset of put buyers. Put buyers purchase put options as a form of insurance against a decline in the price of the underlying stock. If the stock price decreases significantly, the put option buyer may exercise their option and sell the stock at the strike price, protecting their investment. However, if the stock price remains above the strike price, the put option buyer will not exercise their option, allowing the option to expire worthless.
Consider Extrinsic Value
Extrinsic value is an important factor to consider when evaluating the likelihood of assignment. Extrinsic value represents the time value of an option and is influenced by factors such as the time remaining until expiration and market volatility. If there is still extrinsic value remaining in a short put option, it is less likely to be assigned. This is because the put option buyer would prefer to sell the option on the market rather than exercise it, as they would receive a higher premium for the option.
Consider Expiration Date
The expiration date of a put option is another important factor to consider when trying to avoid assignment. If there is a significant amount of time remaining until expiration, the probability of being assigned is lower. This is because the put option buyer has more time for the stock price to decrease below the strike price, making it more attractive for them to exercise their option.
Scenarios for Exercise of Put Options
There are certain scenarios where the put option buyer is more likely to exercise their option. These include situations where the stock price has dramatically decreased and is significantly below the strike price, or where the option is about to expire with little time remaining. In these cases, the put option buyer may exercise their option to take advantage of the downside protection it provides.
Selling Put Option Instead of Exercising
To avoid assignment, it is often more beneficial for the put option buyer to sell the option on the market rather than exercise it. This is especially true when there is still extrinsic value remaining in the option and time remaining until expiration. By selling the option, the put option buyer can receive a premium for the option, effectively closing out their position and avoiding the need to exercise the option.
What to Do If Assigned
If an investor is assigned on their short put option, there are a few actions they can take to manage the situation.
Broker’s Obligation to Buy Underlying Stocks
When assigned, the investor is obligated to buy the underlying stock at the strike price. The broker will execute the purchase on behalf of the investor and deduct the necessary funds from their account. It is important for the investor to have sufficient funds to fulfill this obligation.
Dealing with Margin Call
If the investor does not have enough funds to fulfill their obligation, they may receive a margin call from their broker. A margin call requires the investor to deposit additional funds into their account to cover the cost of purchasing the shares. It is important for the investor to understand the implications of a margin call and take prompt action to meet the requirements.
Selling Shares and Selling Another Put Option
In order to fulfill their obligation and manage the situation, the investor may choose to sell the 100 shares they were obligated to purchase. This allows them to liquidate their position and potentially minimize any losses. Additionally, the investor may choose to sell another put option at the same strike price but with a longer expiration date to reinstate their position and continue their options trading strategy.
Early Assignment and In The Money Put Options
There is a possibility of early assignment if the short put option is in the money. Early assignment occurs when the put option buyer exercises their option before the expiration date. It is important for investors to be aware of the potential for early assignment and take appropriate action to manage the situation.
Methods to Avoid Early Assignment
To avoid early assignment, investors can employ various methods that focus on minimizing the probability of assignment.
Defensive Method
The defensive method involves rolling out and down the option to prevent it from going in the money. By rolling out the option, the investor extends the expiration date, giving the stock more time to move in their favor. Rolling down the option involves lowering the strike price, reducing the chance of the option being in the money.
Extrinsic Value Preservation Method
The extrinsic value preservation method involves rolling out or rolling out and down the option when there are roughly 21 to 30 days left until expiration. This method takes advantage of the time decay of options and aims to preserve the remaining extrinsic value in the option. By rolling out or rolling out and down, the investor extends the expiration date and potentially lowers the strike price, reducing the probability of assignment.
Choosing the Right Method
The choice between the defensive method and the extrinsic value preservation method depends on individual comfort and the type of underlying asset. Different methods may be more suitable for individual stocks compared to index ETFs, so it is important for investors to assess their risk tolerance and preferences when choosing a method.
Defensive Method
The defensive method is one approach to avoiding early assignment on short put options.
Rolling Out and Down the Option
When employing the defensive method, the investor rolls out the option to a later expiration date and rolls down the option’s strike price. By doing so, the investor can avoid assignment if the stock price remains above the new, lower strike price. This method aims to keep the option out of the money, reducing the likelihood of assignment.
Preventing the Option from Going In The Money
The primary goal of the defensive method is to prevent the short put option from going in the money. By rolling out and down the option, the investor gives the stock more time to move in their favor and reduces the chance of the option being in the money. This allows the investor to continue their options trading strategy without the risk of assignment.
Extrinsic Value Preservation Method
The extrinsic value preservation method is another approach to avoid early assignment on short put options.
Rolling Out or Rolling Out and Down
When employing the extrinsic value preservation method, the investor rolls out the option to a later expiration date or rolls out and down, which involves changing both the expiration date and the strike price. This method aims to preserve the remaining extrinsic value in the option, leveraging the time decay of options.
Timeframe for Applying the Method
The extrinsic value preservation method is typically applied when there are roughly 21 to 30 days left until the option’s expiration. At this point, the option has experienced a significant amount of time decay, and rolling out or rolling out and down can potentially capture some of the remaining extrinsic value.
Consideration for Individual Stocks or Index ETFs
When applying the extrinsic value preservation method, it is important for investors to consider the type of underlying asset. Different methods may be more suitable for individual stocks compared to index ETFs, as they may have different levels of liquidity and volatility. It is important to assess the specific characteristics of the underlying asset when choosing a method.
Conclusion
Understanding the risks and methods associated with short put assignment is crucial for options traders. By employing strategies to avoid assignment and manage the situation if assigned, investors can minimize potential losses and navigate the complexities of options trading. It is important to continually educate oneself on these methods and stay informed about market conditions to make informed decisions.