This was supposed to be a safe low-loss trade that went terribly wrong due to some bad decisions that I made. Hopefully, you can learn from my mistakes and not make these decisions that can balloon your losses.
On 21 Nov 22, I had 20 open contracts of Apple Bull PUT Spread.
I received USD4.87 credit per contract for a spread difference of US5, which means my maximum loss per contract is USD13. At 20 contracts, the max loss at expiration (2 Dec 22) would be USD260.
On 22 Nov 22, I was surprised to see that I have an extra 900 Apple shares in my IBKR account. My total spread contracts for this position dropped to 11 (from 20).
This means that there were an early assigned of the SELL PUT (Strike Price $170) contracts. I also had 9 BUY PUT (Strike Price $165) options contracts in my account. This means the buyer on the opposite end of my SELL PUT contracts has decided to activate this contract early to sell his Apple shares to me at USD170.
This is usually uncommon as the PUT options buyer can get almost the same percentage gain or even higher gain by selling away his options contracts, thus keeping his Apple shares for long term investment. Besides, PUT buyers often do not need to own the shares before buying a PUT options contract.
The only reason that I can think of for this move (early exercise of options contract) is that PUT buyer is taking this opportunity to get offload his Apple shares because he is not confident of Apple’s medium or long term future. He might as well sell the shares at the strike price than to earn from the options contract but slowly see his share price drop month by month.
Early Assignment of 900 Apple Shares
I wasn’t ready to own 900 Apple shares so I want to get rid of them quickly. I have been assigned early on another contract which was around 200 shares and I sold Covered CALL on them. This time round, it was too many shares to own and I do not have the cash to buy 900 Apple shares, which equate to around USD153k based on the purchase price of USD170 per share. As I do not have so much cash in my account, I could end up going on margins if I wish to continue owning the shares.
How To Deal With Early Assignment/ Exercise Of Contract?
There are a few ways to deal with this early assignment and it is important to stay calm and not panic. You are actually protected by both bullish and bearish outcome. If the subsequent trend is bearish, the PUT contracts increases in value while the share price drops. If the trend is bullish, the PUT contracts loses value but the share price increases.
Method 1: Exercise The Buy PUT Contract
The first method involves you exercising your BUY PUT options contracts to sell your shares at the strike price of USD165, making a loss of USD5 per share. However, do bear in mind that you have previously received USD4.87 for this vertical spread contract. Thus, the net loss is only USD0.13 ($5 minus $4.87), which is the max loss for this vertical spread contract. This move will involve some comission from your brokerage to exercise the options contract.
Method 2: Sell Away Your Shares & Options Contract
The second method, which also conveniently avoid the commission required to exercise the options contracts, is to sell away your shares and options contracts separately. As mentioned early, owning both the shares and options contracts is a type of protection against bullish or bearish outcomes. Many people buy PUT options contracts as a hedge against their share price dropping, so that even if the share prices fall, they earn an increased premium from their options contracts. So, depending on the premium prices of the options contracts and the share prices when they are sold, the nett difference could be lower or higher than the maximum loss stated in Method 1.
How Did I End Up Such A Big Loss When It Is Essentially Low Risk/ Loss?
At the point when I decided to do something about my 900 Apple shares and 9 BUY PUT Contracts, I realised that Apple share price was dropping. There was bad news coming out of China about workers going on strike at Foxconn iPhone factory. I thought of a way to take advantage of the situation.
I sold my Apple shares (thinking that it may go lower) in order not to sell at a lower price. I kept my PUT contracts as they were increasing in value as the share price of Apple dips.
My breakeven price of my PUT contracts was around USD17.67 (USD170 minus US4,87 credit received minus sold price USD147.46 of the Apple shares).
What I did not expect was after selling the shares, Apple share price started to rise. As the share price rose, my PUT premium prices dropped in value which got me in a disadvantageous position.
I had a chance to cut loss that day to cut loss at USD16.67, which meant a total loss of USD900 but I decided not to as I was not able to accept that I had to 7x my max loss due to a misjudgement. I ended up holding on, hoping that the share price could drop for me to breakeven on my PUT contracts.
I knew time was limited as the contracts were due to expire one week later on 2nd Dec, which meant I did not have much time to wait for Apple share price to drop in the near future. The biggest game changer could come the following day during the release of the FOMC minutes. I decided to take a risk to wait till the release of the FOMC minutes before selling away my Apple PUT contracts.
Market Rose On Dovish Fed Minutes
I woke up in the middle of the night (2pm Eastern Time Is 3am Singapore Time) to eagerly wait for the release of the Fed Minutes. As it turned out, the minutes signalled a possible slowdown of interest rate hikes and the market reacted positively.
Apple’s share price rose again and it seemed that Apple may just go on a rally toward the holiday season. I sold all my PUT contracts at a loss of USD 3,036, which wiped up half of my profits made for Nov 2022. I also added some Apple CALL options contracts to capture the upside of Apple share price rise.
Apple Share Price Fell After Thanksgiving Holiday (Double Whammy)
After the holiday on 24th November, Apple’s share price fell close to 2% during the half-day session on 25th November. It was trading at more than $3 down at one stage on 25th November. Had I waited one more trading day before selling off my PUT contracts, I would have closed them with a significantly lower loss.
Concluding Thoughts
While it was a bitter pill to swallow, especially after cutting huge losses on 23rd November and seeing the share price drop on the following trading day, this serves as a good learning experience for me. The hindsight vision is always 20/20 and it is always easy to look back and said:”I should have done this”. On the day I cut my losses, I was very cautious of another huge rise on the next trading day (25th November 22) that would have caused a bigger loss than USD3k. I felt that it was absolutely necessary at that point in time.
If a similar incident were to happen again, when one leg of my vertical spread gets assigned, I would probably sell away the options and shares and take the max loss, rather than trying to predict what’s coming next and got caught with either options or shares. I hope you find this sharing useful and may you avoid this costly mistake that I have made in trading using vertical spreads and I hope you also find some useful pointers to help you plan your trades if one leg of your vertical spreads gets assigned/ exercised.
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