One of the strategies we use to hedge stock positions is a collar. This consists of long stock with an out of the money put (aka: married put) for protection funded in part by a short call (aka: covered call). There’s actually an entire chapter dedicated to it in our book Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term.
From time to time there is a chance that because of the short call, that the long stock gets called away. As a reminder, when selling calls against long stock, you are obligated to deliver it at the strike price. That is what you get paid for when bringing in the premium.
There are two scenarios where this occurs, both of which are when the call is in-the-money (ITM). Meaning that the price of the underlying stock is higher than the call strike. The first is at expiration and your broker will automatically sell your stock at the strike price. This usually comes as no surprised because as the holder of the stock you will see it coming.
What may come as a surprise is when you get assigned earlier than expiration. That means that whomever you sold the contract to decided to exercise their right and called the stock away from you. This will almost never happen when the stick is OTM and rarely happens when it is barely ITM. But you should expect it when the stock is deep in the money. The likelihood of this goes us significantly if it is a stock or ETF that has a high dividend and should actually be expected the day before the ex-dividend date.
Here’s why. Many times the value of the dividend is high enough that someone can buy the deep ITM call (the call you are actually short) for a cheaper time value than the amount of the dividend.
This has actually happened to some of our clients recently in the ETF LQD. LQD is an ETF that holds corporate bonds and has a dividend of about 4.2%. This works out to be around .40 cents a month as the stock trades around $117. This means that the market maker on the other side of that trade can call the stock away the day before the dividend date and get the dividend cheaper than what they could have bought the stock for.
Its tough for individual investors to get this kind of trade because they can’t get the execution that makes it work. But for those setting the market, it gets easier to build those fills when the public is willing to sell at the right price.
Of course in both situations you keep the premium you generated from the call you wrote and sold the stock at a higher price than what you sold it for. All in all, its not the worst thing to happen to you. The downside is that you no longer have the stock or ETF that you wanted AND you most likely have a taxable event. I actually think the tax consequences are the biggest downside to this trade, but then again, paying taxes means you made money and again…that’s a good thing.
So what do you do next? First thing is to figure out what to do with that put you bought. Remember the collar consists of three legs and although two of them are now out of your account, the put remains. This means it’s time to reassess if you want to get back into that position.
If so, great, you already have a protective put in the account. Odds are its much farther away from the price of the stock today than it was when you put it on. This is because presumably your stock went up which is why you got assigned. But there may be some value left in it that can be used for rolling to another strike.
If you don’t want to buy the stock back, then you don’t have to. With the LQD positions I referenced before, we have not gone back into the positions because our thesis is that bonds are at near-term highs. We will actually re-enter once there is a 3-5% pullback in the ETF. However, we’re going to hold onto the put we have that will appreciate in value if the underlying does indeed retrace a bit and actually reassess at that time.
Bottom line is you’re always given choices when it comes to options; so don’t worry. When something happens like an assignment, you’re still able to manage your positions. It just may mean its time to retest your logic sooner than expected.
Got Assigned? Now What?
by Jay Pestrichelli on March 2nd, 2012
Posted in Options Markets, Stocks, Hedging Techniques Tagged with no tags
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