Short options called away as part of a spread, now what?

S

swag

Howdy options forum, I have a hypothetical question.

Put on an SPY underlying, OTM Call Diagonal (using prices from a couple minutes ago):


BUY +11 SPY Jan12 122 Calls @ 3.75
SELL -8 SPY Dec11 119 Calls @ 3.64


This spread prefers price to stay in the range, though also benefits from IV increase if we revisit 45+ VIX. That said, I've never understood what you would do if some of your short options get called away if they go ITM?

For example, SPY right now is exactly at 120. Imagine we have a Christmas rally and shoot up to 130 next week. At that point, 4 of my short 119 Calls get called away. Also assume I've been delta hedging a bit on the upside so I'd prefer to keep the original spread all the way through to expiration.

What would you do in this spot? I was thinking maybe you could sell options to match the delta of the original position (and that would make your risk look the same) but not sure if that makes sense. I've also read on this forum that getting options called away early is a good thing....how is that possible? They lose whatever time value is remaining, sure, but if those options are part of a spread doesn't that mess up your overall position?

Thanks and Happy Holidays!
 
Quote from swag:

Howdy options forum, I have a hypothetical question.

Put on an SPY underlying, OTM Call Diagonal (using prices from a couple minutes ago):


BUY +11 SPY Jan12 122 Calls @ 3.75
SELL -8 SPY Dec11 119 Calls @ 3.64


This spread prefers price to stay in the range, though also benefits from IV increase if we revisit 45+ VIX. That said, I've never understood what you would do if some of your short options get called away if they go ITM?

For example, SPY right now is exactly at 120. Imagine we have a Christmas rally and shoot up to 130 next week. At that point, 4 of my short 119 Calls get called away. Also assume I've been delta hedging a bit on the upside so I'd prefer to keep the original spread all the way through to expiration.

What would you do in this spot? I was thinking maybe you could sell options to match the delta of the original position (and that would make your risk look the same) but not sure if that makes sense. I've also read on this forum that getting options called away early is a good thing....how is that possible? They lose whatever time value is remaining, sure, but if those options are part of a spread doesn't that mess up your overall position?

Thanks and Happy Holidays!
More...

It's a good thing because you immediately monetize your time value. But you won't be called away unless the underlying is about to go ex-div. For the spy, this will happen just before expiry (the thursday night) so it's largely an irrelevant issue. However, you do have delta risk but you are hedging that.

If you were sub-optimally exercised, you will need to readjust your position and potentially your capital investment.
 
As an aside, to avoid this I could simply dabble in European style options, like SPX, NDX, XSP, etc. but I figured that since most options are American style, eventually it is possible European style options could disappear because of lack of demand? Obviously not anytime soon (considering the volumes in SPX), but just a thought.
 
Quote from newwurldmn:

It's a good thing because you immediately monetize your time value. But you won't be called away unless the underlying is about to go ex-div. For the spy, this will happen just before expiry (the thursday night) so it's largely an irrelevant issue. However, you do have delta risk but you are hedging that.

If you were sub-optimally exercised, you will need to readjust your position and potentially your capital investment.
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Hi newwurld,

when you say readjust your position, do you think it's possible to replicate something that looks like the original position or is that just me daydreaming? Considering SPY has moved 10 points?
 
Early assignment if your short is a good thing. You get all the time premium, and increase you potential downside profit if the ETF were to fall.

BTW: with this ratio spread, your max profit in NOT between strikes. Your betting the SPY blows through 122, your long 3 extra calls.
 
Quote from swag:

This spread prefers price to stay in the range, though also benefits from IV increase if we revisit 45+ VIX. That said, I've never understood what you would do if some of your short options get called away if they go ITM?

For example, SPY right now is exactly at 120. Imagine we have a Christmas rally and shoot up to 130 next week. At that point, 4 of my short 119 Calls get called away.
More...
First issue is margin if you don't have the cash to cover the assignment loss. If not, sell some of the long calls. If so...

Early exercise is a good thing because you maximiize the gain on the short leg before expiration. You could sell more premium or short shares. For example, at 130, the Jan 134 or 135c might give you the same premium that you got for the original 119c's. Now you have soome diagonals and some verticals.
 
Quote from rnrow:

BTW: with this ratio spread, your max profit in NOT between strikes. Your betting the SPY blows through 122, your long 3 extra calls.
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Actually, not exactly. SInce he's short 8 of the lower strike, he has 24 pts to make up with a large rise (8x the diff in strikes). Yes, he has 3 more of the higher strike but with its lower delta, it won't overcome the loss until the high 130's, maybe low 140's.
 
Quote from rnrow:


BTW: with this ratio spread, your max profit in NOT between strikes. Your betting the SPY blows through 122, your long 3 extra calls.
More...


The position does carry the homerun potential if SPY made a legit move north of 130 but I wasn't banking on that, rather I was looking at it from the 'tent' spread perspective, with the caveat if vola blows out you have a little built in downside protection to weigh your options.

The move to 130 I proposed in the original post was just a hypothetical 'stress test' for the options being 10 points in-the-money and what to do thereafter.
 
ratio back spreads, +8, -11 if done for a credit, make money with SPY down or up alot. In the middle, you will likely lose money.
 
Quote from swag:

Hi newwurld,

when you say readjust your position, do you think it's possible to replicate something that looks like the original position or is that just me daydreaming? Considering SPY has moved 10 points?
More...

No. Because you are 10 points away from your strikes. So your position has very different dynamics than it did when the SPY was lower. Further, as you now have stock instead of short calls, your position is further changed. Your position is radically different than it was before.
 
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