Assignments Ain't That Bad

by Jay Pestrichelli on February 1st, 2012

When using collars, from time to time your short calls will get assigned and you will deliver your stock. Don’t worry about it, things could be worse.

Lets back up for a second and review what it means to be in a collar. It means you have long stock that is protected by a put (married put) and a short call against the stock as a means of generating income (covered call).

At Buy and Hedge, we like to use this strategy for stocks that have a desired dividend, but put protection itself is on the expensive side. The calls help keep the hedging cost in our target range of 2-3%.

Collars will limit the downside at the cost of giving up some upside. So what happens when the stock makes a move higher than the upside limit? First thing you should do it pop the Champaign because you’ve got a winner on your hands and you’re making money (a good thing). This call is considered to be in-the-money (ITM) and you are obligated to sell it at the strike price.

What happens next is up to you. You are faced with two choices. Do nothing and let the stock get called away at expiration or roll the call to the next month and generate income again. When we say roll we mean cover the near-term call you have that is in the money and sell another one for additional time value for the next period.

However, from time to time, you won’t have a choice on your ITM calls and you can get assigned ahead of expiration. After all as the seller of the call you are obligated to meet the request of the call owner. That’s the deal when you sell calls and get premium. That means that you’re probably missing out on some of the upside that the underlying ran to.

Odds are if your assignment occurred before expiration, it was because the stock was paying a dividend and the call buyer now wants to get it. The figures work out that the caller of the stock can make more money buying it from you at a market discount plus the dividend for a better profit than the value of their ITM call.

The market is up 20% since October 3rd, a particularly expensive time for options, so many of you may have an assignment occur as your calls have gone ITM. Don’t worry, its not a bad thing. It usually means that you’ve sold the stock higher than you bought it (again a good thing), you kept your premium that you sold the call for (a good thing) and now you’re in a cash position.

The only cleanup is to figure out what to do with the protective put that is left over. You’ve got three choices:

  • Sell it right away if you are bullish on the underlying and just want to capture the remaining value.,
  • Hold it if you’re bearish, and expect a little pull back and treat it as a stand-alone trade.
  • Exercise it and go short it you’re REALLY bearish.

It depends on your bias. I’ve seen it go well in all three of these scenarios before, but one thing for sure is its time to re-assess your feeling on the position.

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