If you have account already, Log in here first

Log In
  • en
    • cs
Menu

Trading System for Short Efficient ETFs – Part 5 – What to do when assignment occurs?

3 May 2018,

In the last part of the educative series, I mentioned that there is a certain risk of assignment when shorting inefficient ETF markets through bear call spreads. This is usually the case when the option strike is in-the-money, and there is practically no time value for the sold option. What does it mean for us as an option trader? Simply, instead of 1 sold call option, we will have 100 pcs. of the underlying market in a short position, ie 100 pcs of ETF: UVXY short.

Maybe you’re thinking where the problem is, because we’re still holding a protective bought call option with a higher strike. This is of course true, but when shorting ETFs, such as ETFs linked to volatility (VXX, UVXY, …), this short is charged with a so-called borrowing fee (in short, there is a cost of shortening). Its amount varies according to the current availability of shares to short, but it is often more than 10% (currently at UVXY around 15% pa). Typically it occurs in a situation when we do not like it, ie forced assignment of our option position occurs at higher market value, when this fee is usually higher. The borrowing fee is charged for each holding day and is therefore calculated from the full value of the position.

Therefore, if we have our original position (1 option contract), then 100 pcs of the short ETFs will be assigned. If the actual value of that ETF is for example 15, then the total value is 15 x 100 = 1500 USD. Simply said – if the borrowing fee is 10% (here we have described how to find it), then we will pay 150 USD for one year of holding, converted to days is about US $ 0.40 per day.

It is not a huge value, however, with a longer holding, it can significantly change the profitability of our trading strategy. So, let’s see what scenarios can be suggested. I note that this is not a complete list of possible variants. It very much depends on the particular position of the underlying market, the volatility level, the amount of contango / backwardation, etc.

 

  1. Close the remaining position

The first and easiest way is to end the position. Ideal is to enter a trading command (for example in the TWS platform) as a Buy Write strategy that is buying the shares + selling the call option.

Consequently, it is possible either:

  • Open a bear call spread position with the same expiration, but with a higher strike of the sold call option (it is important to watch the time value).
  • Open the position with even a longer expiration, but it is also necessary to watch the time value.

In both cases, except for the time value of the listed options, you need to keep tracking the strategy RRR. I do not find it reasonable to “catch up” the possible small loss made by the assignment by choosing safer (ie closer) strikes of the options, but at the price of a very unfavorable RRR of a given spread.

  • Open the bear-put position. However, here too, it is necessary to follow the RRR of our strategy. As explained previously, put spreads are more conservative option, but at the cost of a less favorable RRR strategy.

 

  1. Sell put options to the assigned shares

 

  • Naked put options

The cost of the stock borrowing can be eliminated by selling the put options against a short position of the ETF. If the original bear-call spread has a long-term expiration (a year), then the put options can be on a weekly basis.

Put option should be sold OTM, ie several % below the current ETF price. It is ideal for the selling if the market is backwardation or not in a significant contango. In this case, there is less likely that sharp decline will occur, and our put option will get to an unpleasant loss. It would be quite difficult, for example, to roll it for a week or more without losing the premium.

 

  • Bull put spreads

If the ETF value is high and the margin on the uncovered put option is already too big, it is possible to open the bull put spread strategy. Risk and losses are limited, in the case of a significant drop of the market, the entire spread can be rolled, or we can open instead of it a naked put option (depending on the ETF’s current value).

 

  1. Stay in the trade, but set a time stop-loss

Basically, this is also a valid way to handle the position, especially if we expect a rapid return of the underlying market back. In such a case, it is not necessary to close the position immediately, but it is possible to leave the trade on the market and set a time stop-loss, until when we can hold (despite accumulated short costs) the position, respectively how long we can hold it (it can be several weeks, several months, depends on many circumstances).

After this time, one of the methods listed under 1 or 2 may be used.

As you can see, the assignment is not a disaster for short inefficient ETFs. It is important to keep a cool head and choose one of the ways to manage the position I have described above or use a combination of them. It is always important to have a plan and be ready. All the best!

Option report

Get your report from Jan Kaska's trading every week!

02-2018-05-11-account-overview

Leave a Reply

Your email address will not be published. Required fields are marked *