Maximum Loss on OEX Options Credit Spreads

Topic: Maximum loss on an OEX options credit spread may be more than you think

Warning: Unless you know or care about option credit spreads, you may find this letter very long and very boring!

Dear Options Trading FAQ:

In your last post, you mention that the max loss on an OEX option credit spread may be greater than what my broker tells me. I thought it was the difference in strikes less the premium generated. So what are you thinking of?

Don't know who to believe

Dear Unbeliever:

Here is an article for an option column back in the spring. I'm too lazy to update the strike prices in this example, but the principle remains the same.

OEX SPREADS: THE HIDDEN DANGER

Did you ever have your carefully planned OEX (S&P 100 Index) options spread position obliterated by an early assignment? Scrambling to re-establish the strategy after your broker calls you with the notice is bad enough, but do you realize the hidden danger in this cute trap?

With spreads on American-style (early assignment feature) Index options, there is the risk of losing a great deal more than you thought possible. Here is what can happen.

Let's say right now you are bearish for the near-term and sell 10 OEX May 485 Call options for 3 1/2 and buy 10 OEX May 490 Calls for 1 1/2. The net credit (3 1/2 minus 1 1/2) is a realized gain of $2,000 if the OEX closes anywhere below 485 at the May expiry. The maximum potential loss, so you think, is the difference between the strike prices and that net credit (5 minus 2 = 3, or $3,000). But that is true only for European-style options where early assignment is not allowed. In our scenario, your broker calls you on expiration morning to inform you that your 10 short OEX 485 Calls have been assigned at last night's close. With the OEX at 495, that means a debit to your account of $10,000 (OEX 495 minus your strike of 485), leaving only just the 10 long OEX 490 Calls.

Unfortunately for you, the market opens sharply lower and your calls open way down. You sell them at $2, off three points from yesterday's close, which turns out to be the high of the day and they are offered only 1/16 at the bell. Your total loss in the position is now $6,000 (original credit of $2,000, less assignment debit of $10,000, plus long side sale of $2000). This is twice what seemed to be the maximum loss possible.

Of course, had you not sold the long side, holding them until the close, the loss could have been $8,000!

Many people assume that you can respond to the assignment notice by exercising the long side of the spread. This is incorrect in that you would be too late to be entitled to yesterday's closing OEX value. An exercise at this point would be settled according to the current day's level.

Of course, the OEX could open higher instead of lower, but it doesn't often work that way. In fact, this past February saw the largest number of call assignments for a single day in the history of the OEX. That occurred after the close on the Thursday before expiration day. The market did open down substantially the next morning to trap plenty of OEX spread traders.

How to avoid this hazard? Bernie Schaffer of Investment Research Institute suggests trading the SPX (S&P 500 Index) options which, with its European-style feature, cannot be exercised early. Why doesn't everyone do this? Michael Evans of Evans Economics, who also uses the SPX, points out that the spreads on the S&P 500 are wider than on the OEX and that those eights and quarters can add up if one is not careful. Entering and exiting a spread trade could mean a 1/2 point sacrifice if one loses an extra eighth on each side.

Actually, you could spread the OEX and avoid an early exercise if you keep a close watch on your short option. As long as that option retains some time value over its intrinsic worth, early assignment is unlikely. If late in any day, it is trading at a discount to its intrinsic value, you should consider closing the position and rolling to a higher strike or a later month. Also keep in mind that the danger of early assignment increases greatly as an option gets deeper in the money and as it approaches expiration day.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Expiration, Options Spreads, Options Strategy

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