What Happens If You Get Assigned on a Poor Man’s Covered Call?

The “Poor Man’s Covered Call” (PMCC) aims to replicate a traditional covered call with reduced capital. Instead of holding 100 shares, a PMCC utilizes a long-term, in-the-money (ITM) call option, often a Long-term Equity Anticipation Security (LEAPS), as a substitute for shares. Against this long call, a shorter-term, out-of-the-money (OTM) call option is sold to generate income through collected premiums. This article explores what happens when the short call option in a PMCC strategy is assigned.

Understanding Assignment in a Poor Man’s Covered Call

Assignment in options trading refers to the obligation of an option seller to fulfill the terms of the contract when the option buyer chooses to exercise their right. For a short call option, assignment means the seller is obligated to sell 100 shares of the underlying stock at the strike price of the assigned call. The Options Clearing Corporation (OCC) manages this process as the central clearinghouse for options trades.

An option buyer can exercise their American-style call option at any time before or at its expiration, particularly if it is in-the-money. When a buyer exercises a call option, their brokerage firm sends an exercise notice to the OCC. The OCC then randomly selects a clearing member firm that has a short position in that specific option series.

Once the clearing member firm receives the assignment notice from the OCC, they then assign it to one of their own customers who holds the short option. This internal assignment can be done randomly or on a first-in, first-out basis, depending on the brokerage firm’s specific procedures. The option seller is notified of the assignment, typically after market close, indicating they must deliver the shares.

The risk of assignment increases as a short call option moves deeper into the money, especially as its expiration date approaches. Early assignment can also occur if the underlying stock is about to pay a dividend, as the call buyer might exercise to become eligible for the dividend. Since a PMCC does not involve owning the actual stock, an assignment on the short call creates an obligation to sell shares that the trader does not possess.

Financial Implications of Assignment

Assignment on the short call in a Poor Man’s Covered Call has direct financial consequences, obligating the trader to sell 100 shares of the underlying stock at the short call’s strike price. Since the PMCC uses a long call option instead of actual shares, the trader does not immediately have stock to deliver, creating a short stock position.

The overall profit or loss of the PMCC upon assignment depends on the strike prices of the long and short calls, and the premiums paid and received. Maximum PMCC profit is generally realized when the stock price is at or just below the short call’s strike price at expiration. However, if the short call is assigned, especially if it moves significantly in-the-money, the trader must sell shares at a price potentially much lower than the current market value.

To calculate the net financial outcome, consider the premium received from selling the short call and the cost of the long LEAPS call. If the short call is assigned and the long LEAPS call is deep in-the-money, the long call can be exercised to acquire shares to cover the short stock position. However, exercising a long call early forfeits any remaining extrinsic value (time value), which can reduce overall profitability.

If the long call is not exercised or is not sufficiently in-the-money, the short stock position becomes a separate liability. This requires the trader to either buy shares in the open market to cover the short position or maintain a short stock position, necessitating significant margin capital. Initial margin requirements for short stock positions are typically 150% of the short sale value, though maintenance requirements can vary. If the stock price continues to rise after assignment, losses on the short stock can accumulate rapidly, potentially leading to a margin call.

Actions After Assignment

Upon receiving an assignment notice for a short call in a Poor Man’s Covered Call, immediate action is often required, as the trader is obligated to deliver shares they do not own. Brokerage firms handle assignments in various ways. Some may automatically exercise an in-the-money long call option in the same account to cover the short stock obligation. This automatic exercise is not universal, and some brokers require explicit instructions.

If the long call is automatically exercised, the acquired shares fulfill the assigned short call obligation, closing the short stock position. This converts the PMCC into a realized profit or loss based on the strike price difference and premiums. However, this action causes the long call to lose any remaining time value.

If the broker does not automatically exercise the long call, or if it is not sufficiently in-the-money, a short stock position is created in the trader’s account. In this scenario, the trader has a few options. One approach is to manually exercise the long call option to obtain shares to cover the short stock. This is advisable if the long call is deep in-the-money with minimal extrinsic value remaining.

Alternatively, the trader can close the resulting short stock position by buying shares in the open market immediately after assignment. Simultaneously, the long call option can be sold to realize its remaining value. This two-part action allows the trader to manage the short stock obligation while potentially retaining some extrinsic value from the long call, as selling an option often yields more than exercising it if time value remains. Ignoring an assigned short stock position can lead to substantial losses due to rising stock prices and potential margin calls, requiring additional capital or liquidation of other assets.