"What To Do When Short Leg of Put Spread is Assigned?"
Question By Ken
"If a short put, which is part of a vertical Spread, is assigned & I don't have enough cash in my options account to buy the stock, can I just close the put option by buying it back?"
Asked on 3 June 2011
Answered by Mr. OppiE
Put Vertical Spreads are options trading strategies consisting of simultaneously buying and writing put options of the same expiration month at a different strike price, are extremely common options spreads used for the purpose of reducing, capital outlay or reducing margin requirement. The two most common put vertical spreads are the Bear Put Spread and the Bull Put Spread. Both of them consist of buying put options at one strike price and then writing the same number of put options against them.
Theoretically, margin is eliminated (as in the case of Bear Put Spread) or reduced (as in the case of Bull Put Spread) due to the fact that the long put options provide a hedge or "collateral" against the writing of the short leg. Without the long leg, writing the short leg would expose the writer to the full margin requirement for writing naked puts. As such, theoretically, when the short leg of a put vertical spread is put under early assignment, the whole options trading position should be dissolved. However, that is not the case in reality.
In reality, even though the long leg provide a collateral for the writing of the short legs, each option in a options spread is treated individually by the broker when it comes to dissolving the options trading position. As such, when a short leg of a put vertical spread is assigned early, you would actually retain the long legs while simultaneously owning the underlying stock at the strike price of the short put options assigned. However, in most cases, the account holder usually do not have enough cash/margin to take delivery on the underlying stock itself. In such cases, the broker will automatically sell the resultant long stock position leaving you with the resultant profit/loss from the transaction and the long put leg. When your short options are marked for assignment, the process takes place immediately so there will be no time for you to manually close out the short put leg at all.
Even though such a partial liquidation of a options spread position might sound scary and complex, it actually works to your advantage if your broker is good enough to cover the whole transaction of exercising the puts and selling the resultant stocks simultaneously with minimal slippage. Yes, it is advantageous because of the fact that when you write options, you really want to profit from the decay of its extrinsic value which happens completely only upon expiration of those short put options. When your short put options are assigned early, the entire extrinsic value evaporates all at once, so you profit from it before even reaching expiration, allowing you to reap an early profit or to write a second short put leg within the same month. In either case, your returns increases if the slippage from the transactions do not end up to be more than the extrinsic value of the short put leg.
You should also take note of the position resulting from such an early assignment. When the short leg of a Bear Put Spread is assigned early and liquidated due to lack of funds, you will be left with a long put position which has unlimited profit with limited risk. You can then write yet another out of the money short put in order to further increase profitability. When the short leg of a Bull Put Spread is assigned early and liquidated due to a lack of funds, you will be left with an out of the money long put position which change the nature of the position from a bullish options strategy to a bearish options strategy. You should then take measures to adjust the position in order to maintain its bullish stance if you are still bullish on the underlying stock.
In conclusion, when you own a put vertical spread and do not have the funds to take assignment on the short put options, your brokers would usually liquidate the resulting stock position automatically, posting the resultant profit or loss in your account. You would not normally be given the time or pre-warning to manually close off the short put options since the assignment takes place almost immediately upon receipt.
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