Option Assignment on Option Expiration

What happens when you get an option assignment exactly at the option expiration date on a short call vertical spread? If you don’t exit a short call vertical spread at option expiration and it closed the middle of the strikes, then you will get assigned on the short call creating a short position the next Monday.

Accidental Option Assignment

This position was accidentally created on Feb 19th trying to exit a FXE short call vertical spread 107/109 spread, that ultimately closed in between the two strikes. FXE is the ETF that tracks the euro to USD exchange rate. It replicates the EUR USD exchange rate with decent liquidity of about 750,000 shares a day for the ETF and options that trade with penny wide option pricing.

To make it slightly more complicated this trade was in an IRA account, and brokerages do not allow short positions in retirement accounts. Important: You should contact your broker before market open if you got assigned like this in a retirement account like an IRA. This is because your brokerage might take matters into their own hands, i.e. liquidate the short position for you without asking, potentially with a market or in the illiquid pre market with poor pricing (they are within their rights to do this because you are temporarily at least breaking the rules). In extreme cases the broker might also liquidate other positions if your cash balance is very low. You generally must try and buy to close out the short shares as early as possible in the morning session (preferably in the first few minutes of the session). Therefore it would be advisable to contact your broker on the phone before market open to explain the situation. This is because you are not allowed to have a short position in an IRA – if you show willing with your broker that you did your best to try and get out of it that will help your position. Technically it might be possible to hold until the end of day, but as soon as you have a closed overnight position it would should up as a short position at end of day settlement.

How did we get into this mess?

Original intention was to exit a FXE call vertical spread 107/109 call spread on the last 15mins of trading day on Friday. In the last hour on trading on Friday from 3pm to 4pm FXE price ranged from only 108.83 to 108.88, so fair value for the spread never ever more than 1.88 and got as low as 1.83. Placed limit orders to exit at a mid price of 1.85, 1.90, 1.95 up to even 2.0, but never got filled in the last 5mins of trading. That means no one wanted to take the other side of the spread when expiration was only minutes away, even at $0.10 over fair value. It never actually occurred to us that would not be able to get a fill at any price (!). At 4pm market closed with no fill and obviously day limit order for our trade exit was cancelled automatically on market close.

FXE Feb 2016 short call spread accidental assignment - 20160222

Therefore we were forced to hold a net short position of $21,400 over the weekend, assigned on 2 options contracts at $107 (2 x 107 x100 = $21,400). Being short a currency over the weekend is typically not as risky as the stock market, because currencies tend not to move as quickly as equity markets and FXE has been fairly range bound in the last month from approximately $106 to $111. So was not so worried about the open market risk, more the actual exit execution with Fidelity (which actually turned out ok, with the caveats given below).

Trade Exit

FXE only trades US market hours like a standard ETF, where as obviously the currency trades 24 hours x 5 days including overnight. So if you can not get a pre market quote on a currency ETF like FXE, you use a currency trading website like dailyfx.com to track the actual euro price and work out almost exactly where FXE price should open on 9.30am on Monday. The currency chart price does not exactly match FXE price, but you can work this out as follows. Take the closing price on 4pm Friday close from the currency exchange rate chart (1.113) and current price now (1.101 on Monday about 9.30am ish), and work out the percentage change (1.101 – 1.113)/1.113 = about -1.08%. Then taking the FXE closing price from Friday (108.88) apply that percentage change by to give an approximate open value for FXE of about $107.70. We were fine exiting at that price since it was about break even for the original spread position, especially because the option spread was almost a full loser on Friday. For record the actual executed FXE trade price was $107.75 (including commissions).

FXE Feb 2016 short call spread accidental assignment - current chart - 20160222

Since on Monday Euro was down 1% in the morning on the NY open with a mini crash in progress on news of Brexit, we just covered with a market order. Normally we would use limit orders not market orders for exiting stock positions. However our broker (Fidelity) not being able to process a limit order without ringing up every time to cancel and correct it, and then they have to read the entire order back to you over the phone (due to option trading regulations). Cancelling and correcting say 10 times over the phone to get try and get a better fill over the phone is somewhat tedious and would have taken about 30 mins and given the market was moving quickly just decided to take advantage of the move lower on the open. Incidentally Fidelity fee for ETF trading directly with a trader on the phone is $32 (!) – fortunately they waived it as this was a “special case”. You cant be short stock in an IRA, so it was important to close out the position on Monday. Not sure what would happen if position was held onto for a few days, but its probably not a good situation for your account (Fidelity rep on the phone said Fidelity compliance would call, and enforce liquidation of the position or request significantly more cash to back up the short position).

In this case the situation turned out nicely, but generally this is not a good idea – so moral of the story always check your DTE and exit spread with a lot more than 1 hour remaining to expiration! In fact better yet roll 2 or 3 days before – its just not worth the hassle factor of exiting the capital intensive short/long positions on the Monday and the associated market risk. Basically waiting that close to expiration exposes potentially exit issues such as:
- significant gamma risk (losing a lot if the market moves quickly against you)
- inability to exit position at a decent price if you wait until last trading hour into option expiration
- needing to manage the resulting short position the following week

Conclusion

So in summary, a short position can be created in an IRA if an option assignment on a ITM short call spread occurs at option expiration. However if that does happen, it is definitely not a good idea to hold it more than one trading day because it violates IRA brokerage rules. It also may vary with how your broker would handle that in an IRA. For example Fidelity allowed trading out of it, but had to call in to manage that – however other brokers might have issues with that situation. In conclusion it is generally best to avoid getting into this situation in the first place, by not waiting until the last minute to exit and actively monitoring all your positions in option expiration week. Fortunately having done it once, you are not likely to do it again in hurry!

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