Yesterday, the SVXY put we had sold in our ongoing demonstration portfolio was exercised. While this is sort of an inconvenience to contend with, it will give us a learning opportunity. People with little or no options trading experience are often concerned that something awful happens when an option they have sold is exercised. This week’s experience should put their mind at ease.
Every Friday, we will make a trade in this portfolio and tell you about it here. Our goal is to earn an average gain of 3% a week in this portfolio after commissions.
I hope you find this ongoing demonstration to be a simple way to learn a whole lot about trading options.
How to Handle an Option Assignment
Yesterday SVXY fell over $5 a share as the market tanked and options volatility (VIX) soared. Unfortunately, this is exactly what happens every once in a while. It is the one thing that we can’t handle because we are betting that SVXY will move higher in most weeks (as it has about 75% of the time in the past).
We had sold a Sep4-14 90 put on SVXY (which expires today). We sold it at a time when SVXY was trading about $89. Yesterday it closed at $77.25, or almost $9 lower than it was last week. Our short put got so far in the money (i.e., the stock price was much lower than the strike price of the put we had sold) that there was essentially no time premium remaining in this option. Usually, the owner of any expiring put or call is better off selling their option in the market rather than exercising the option. The reason is that there is almost always some remaining premium over and above the intrinsic value of the option, and you can almost always do better selling the option rather than exercising your option.
With the short option about $13 in the money, the owner of that option discovered that he couldn’t sell his option for more than its intrinsic value, so he exercised it. He “put” the stock to us, forcing us to pay $90 for 100 shares at a time when the stock was trading for about $77. When the market opened this morning we had 100 shares of SVXY in our account and no short put.
About an hour into the trading day, we placed an order to sell the shares, collecting $78.34. The stock had rallied just over a dollar since yesterday’s close. We then sold a put at the 81 strike price that will expire next Friday. Here is the order we placed:
Sell To Open 1 SVXY Oct1-14 81 put (SVXY141003P81) for a limit of $4.10. The order was executed at $4.11.
We usually try to sell a weekly put at a strike price which is about $1 out of the money (i.e., if the stock is trading at $78 we would like to sell a put at the 79 strike price). We selected a strike which was $2 higher than that this week because we believe there is a good chance that SVXY will move higher than usual next week. VIX is above 15, and for the past several months, it has averaged between 11 and 13. If it falls back to this range, SVXY is bound to move quite a bit higher.
We were short SVXY puts in one of our Terry’s Tips portfolios yesterday, and we bought them back and sold new puts for next week because the stock had tanked so much and we wanted to avoid an assignment. We didn’t do it in this demonstration portfolio because I have told everyone that we would only be making trades on Fridays.
But the message here is that even when an assignment takes place, it is no big deal to trade out of it. If you were short a put and it was exercised like we experienced this week, you just sell the stock and sell a new put. If you were short a call, you would just buy back your short stock and sell a new call. It’s that simple.