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"What Happens If the Short Leg of My Bull Call Spread Is Assigned?"

Question By Lance

"What Happens If the Short Leg of My Bull Call Spread Is Assigned?"

Do I require funds to cover the write position in a bull call spread if I get exercised on the write position in the trade. Can I avoid having to buy the shares in this situation? what can I monitor to avoid this? What are alternatives to still be able to profit from this particular trade? Thanks.

Asked on 14 June 2011

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Answered by Mr. OppiE

Hi Lance,

Getting the short leg of any options spread strategies assigned early and breaking the position is a very real risk all options position traders must accept and take. Indeed, nothing breaks an options strategy more than the early assignment of the short legs but having the short leg exercised early isn't totally bad.

First of all, before I go into why getting the short leg of a bull call spread assigned early isn't a bad thing, lets first explore the possibility of the out of the money call options in a bull call spread getting assigned early.

Short call options are assigned when someone who bought those call options exercised their rights to buy the underlying stock at the strike price of the call options. When those call options are out of the money, which means that they have a strike price significantly higher than the prevailing market price, there is completely no incentive at all for those call options to be exercised since nobody would pay for the stocks at a price significantly higher than market price and in the process have whatever value in those call options evaporated. As such it is very unlikely for the out of the money leg of a bull call spread to be assigned early.

If you held on to the position to the extend where the stock has rallied past the strike price of the out of the money call options, then the position would already be very close to its maximum potential profit. In this situation, you would be better off closing off the whole position and then reinvesting those capital somewhere else where more options trading profits can be expected.

Now, In the case where your out of the money call options are really assigned early, it is actually a good thing. When you write out of the money options, what you really want is for time decay to wear down its value so that you will make that value as profit or as offset for your long call options. However, short options do not completely decline in value through time decay until expiration day itself. This is when early assignment can be a good thing. If for any reasons you short call options are assigned early, the value of the short call options evaporate immediately all at once without having to hold them to expiration! That's right, when your short call options are assigned, you get a short position on the stock and all of the value of those call options into your account immediately. This will allow you to write some more out of the money call options in the same month, thereby furthering the profitability of your bull call spread.

When short call options are assigned, you will have to sell the stocks to the holder of those call options and if you do not already own the stocks, you will have to short sell the stocks and end up with a short stock position. As such, you won't be buying the stocks as implied in your question. What if you do not have the cash margin needed to hold the short stock position when the out of the money call options are assigned? In this case, your broker would automatically liquidate the short stock position in the open market immediately upon assignment, posting the resultant profit or loss in your account, hopefully with minimum slippage due to bid ask spread and commissions.

If the out of the money call options of your bull call spread are really assigned, you would end up with one of two possible resultant positions:

1. If you have the cash margin to hold the short stock position, you would end up with short shares and long calls which creates a synthetic long put (Read our tutorial on Synthetic Positions). Compare the risk graph of a synthetic long put (which is the same as a long put) and the risk graph of a Bull Call Spread below:

long put risk graph Bull Call Spread risk graph

In this case, due to the addition of the short stock position, the overall position changes from a bullish options strategy to a bearish options strategy which could be totally contradicting to your outlook on the underlying stock. In this case, you would need to close out the short stock position as quickly as possible upon assignment in order to maintain your bullish outlook on the underlying stock.

2. If you do not have the cash margin to hold the stock stock position, you would end up with only the long calls which is a bullish options strategy anyways. You could then choose to hold on to it if you continue to be bullish on the underlying stock or write some more out of the money call options.

In conclusion, it is not likely for out of the money short call options to be assigned early and for a bull call spread, you really should be closing the position before the short call options go too much in the money. If the short call options are assigned early and you do not have the cash margin to hold the resultant short stock position, your broker would most likely liquidate those short stocks for you the moment the assignment is complete.

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