It’s difficult to feel much sympathy for options trading investors who step onto the playing field without reading or understanding the rules. In fairness, it’s not as if this is unusual. How many of us bother to read the fine print when opening a new credit card account even though we know the fine print in these agreements can come back to bite you.
I recently came across a horror story that happened to a rookie options trader that could easily have been avoided. I also know that similar events happen to other uninformed ‘victims’ who don’t publicize their stories.
This trader sold a SPDR S&P 500 (NYSE: SPY) call spread which had moved into the money. On the Thursday night prior to expiration Friday he had been assigned on all of his short call options. He thought nothing of it and when expiration arrived the next day he simply exercised his long calls. Expecting nothing worse than having already lost the maximum possible sum from the trade, he was horrified to learn that SPY had gone ex-dividend on Friday morning and his losses were $48 (per option) worse than expected.
An extra $48 on a spread that is only $100 wide represents a substantial loss. The trader was angry, mystified and, most amazingly to me, thought he should not have to pay the whole dividend. He claimed instead that the payment should be prorated because he was short the underlying shares for only one day.
But that indicates he didn’t know the rules regarding ex-dividend date and short option positions. In a nutshell it can be expressed like this – if the underlying stock or ETF goes ex-dividend, and if you are notified of an assignment on a short call position ON or before the ex-dividend date, you must deliver the appropriate number of shares, and you owe the dividend.
Know the rules before trading.
If you trade shares of an individual stock or ETF, it’s mandatory to know when the stock goes ex-dividend and the value of the dividend.
If the stock does pay a dividend during the lifetime of the option, it’s mandatory to either exit the trade prior to the ex-dividend date or have a plan in place that prevents paying the dividend, that is, if there are no benefits from doing so. In this example, all our ‘victim’ had to do was either exercise his longs for the dividend or buy back the spread — and there would have been no problem.
Know when to give up on a trade. There is no reason to allow a small loss to grow into the maximum possible loss.
Never allow yourself to be assigned an exercise notice when that (often beneficial, but sometimes destructive) event will result in a margin call. If you cannot meet a margin call, then exit the trade when the possibility of an early exercise rears its head.
It’s difficult enough to earn money on a consistent basis — especially for the beginning option trader. There is no reason to jeopardize your entire trading career by not understanding the rules when playing the game.
Follow Mark Wolfinger on his ‘Options for Rookies’ blog: http://blog.mdwoptions.com