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Question By Tony Guzman
"Is Selling ITM or OTM Safer?"
Is it safer to sell ITM calls or OTM calls due to the assignment issue?
Asked on 3 March 2010
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Answered by Mr. OppiE
Hi Tony,
Writing both in the money (ITM) and out of the money (OTM) call options really serves different purposes in options trading. Let us explore the purpose and the risks so that you understand why both ITM and OTM calls are written in the market place despite ITM calls being apparently more at risk of assignment.
There are two main purposes in writing ITM calls in options trading; For the execution of a Deep ITM Covered Call or you expect the stock to drop down to or below the strike price of the ITM call. Deep ITM covered call is almost like an arbitrage technique where you aim to profit from the low extrinsic value of the ITM calls without being subject to directional risk. You definitely can't do this with OTM calls. If you expect the underlying stock to drop down to or below a certain strike price, writing ITM calls at that strike price would obviously generate much more profit than writing OTM calls.
Now, the obvious issue is that as long as you write ITM calls (or puts) you are subjected to assignment. This means that the options contracts you wrote can be exercised by whoever bought your contracts. This is a fact in options trading but to put things into perspective a little, ITM options assignment prior to expiration isn't compulsory and happens randomly with a chance of about 12% only. The closer to expiration and the deeper in the money, the closer to that 12% chance you get. Still, its a pretty low chance.
Now, is being assigned really a bad thing?
First of all, most options writers are aiming to profit from the extrinsic value of the options that are written through time decay. Now, when an option is assigned, ALL of the extrinsic value in that option evaporates all at once, giving you that profit right there and then without having to wait till expiration! In fact, being assigned saves you time from having to wait till expiration so you can move on to other trades.
Assuming you wrote 1 contract of AAPL's $170 strike price call options at $27.50, obtaining $2,750, when AAPL was trading at $195.
If AAPL remained at $195 till expiration, you would make the extrinsic value of $2.50 or a profit of $250.
Assuming you were assigned when AAPL was still at $195. The $170 strike price call options you wrote would disappear immediately to be replaced with 100 shares of AAPL bought at $170 in your account. You can sell those shares immediately at $195 to recover $2500.
You make the profit of 2750 - 2500 = $250 immediately without having to wait till expiration.
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What if you do not have the cash or margin for the assignment?
Well, that is nearly impossible due to the fact that margin is required for all naked write positions in options trading. However, if the option being assigned is part of a spread position that requires no margin, most options trading brokers would just dump the stocks at market price for you during the assignment process, which still serves the purpose of getting out of the position profitably.
In conclusion, both writing ITM and OTM calls serves different purposes in options trading. There are times when you will have to write ITM calls despite the risk of assignment due to the specific objective or strategy you pursue. However, being assigned is not only a low probability event, it is also not totally a bad thing as it helps you achieve your aim of profiting from the extrinsic value of the options written immediately, saving you time.
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Response by Tony...
Reply by Mr. OppiE...
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