What Happens When a Poor Mans Covered Call Gets Assigned?

A “poor man’s covered call” (PMCC) is an options trading strategy that aims to replicate the characteristics of a traditional covered call without requiring ownership of 100 shares of the underlying stock. Instead of holding shares, an investor purchases a long-term, deep in-the-money call option and then sells a shorter-term, out-of-the-money call option against it. This approach allows for a similar bullish outlook and income generation potential with a significantly lower capital outlay compared to buying 100 shares of stock. The strategy becomes particularly relevant for many investors when the short call option faces assignment.

Understanding Option Assignment

Option assignment refers to the obligation of an options seller to fulfill the terms of an options contract when the buyer exercises their right. For a call option seller, this means delivering 100 shares of the underlying stock at the agreed-upon strike price.

A short call option within a PMCC strategy might be assigned if the underlying stock’s price rises above the short call’s strike price. When an option is in-the-money at expiration, it is typically automatically exercised unless contrary instructions are provided. Early assignment can occur at any time for American-style options, especially when an option is deep in-the-money or if a dividend is imminent, as exercising allows the buyer to capture the dividend.

The unique aspect of a PMCC is that the seller does not directly own the underlying shares. Instead, they hold a long call option, which acts as a substitute for the stock. This distinction is important because, upon assignment, the obligation to deliver shares remains, but the shares are not readily available in the account. This necessitates a specific process to fulfill the contract, differing from a traditional covered call where the shares are already owned.

Brokerage Processing of Assignment

When a short call option is assigned, the Options Clearing Corporation (OCC) receives the exercise notice from the buyer’s brokerage firm. The OCC, which acts as the guarantor for all listed options transactions, then randomly allocates the assignment notice to a brokerage firm with clients holding short positions in that specific option series, ensuring a fair assignment process.

Upon receiving an assignment notice, the brokerage firm identifies a client who sold that option. The selection method can vary by brokerage, often being random or based on a first-in, first-out (FIFO) basis. For a PMCC, since the trader does not own the shares, the brokerage typically takes steps to resolve the position.

The broker’s automatic response to a PMCC assignment often involves exercising the trader’s long call option. This action converts the long call into 100 shares of the underlying stock at the long call’s strike price. The brokerage then delivers those newly acquired shares to the option buyer who exercised their short call, ensuring the delivery obligation is met.

The timing of these actions is generally overnight processing, occurring after the market close on the day of assignment. The settlement for stock transactions typically occurs on a T+1 basis, meaning the transfer of money and securities takes place one business day after the transaction date. Therefore, the shares acquired through the long call exercise and delivered for the short call assignment are settled efficiently within this timeframe. While the standard process aims for seamless resolution, situations where the long call is not sufficiently in-the-money or if there are insufficient funds or margin in the account could lead to additional complications, requiring immediate attention from the trader.

Calculating the Financial Outcome

Determining the financial outcome of a poor man’s covered call assignment involves considering initial costs, premiums received, and the effective buy and sell prices of shares. The primary cost is the premium paid for the long-term call option. This is offset by the premium received from selling the shorter-term call option, which reduces the overall cost of the strategy. When the short call is assigned, shares are effectively sold at its strike price. Simultaneously, to fulfill this obligation, shares are acquired by exercising the long call option at its strike price.

A simplified approach to calculate the net profit or loss is to sum the premiums received and paid, then account for the difference between the strike prices of the two options. The formula can be expressed as: (Strike Price of Short Call – Strike Price of Long Call) + (Premium Received from Short Call – Premium Paid for Long Call). For example, if the long call was purchased at a $50 strike for a $10 premium, and the short call was sold at a $60 strike for a $2 premium, and assignment occurs, the shares are bought at $50 and sold at $60. The gross profit from the share transaction is $10 per share, or $1,000 per contract. After accounting for the initial debit of $8 ($10 paid for long call – $2 received for short call), the net profit would be $2 per share, or $200 per contract.

Brokerage fees and commissions also impact the final realized profit or loss. These fees typically include per-contract charges for options trades, and may also include exercise or assignment fees. These costs are subtracted from the calculated profit or added to the loss to determine the net financial outcome. The profit or loss is fully realized and reflected in the account once the assignment and subsequent transactions are resolved and settled.

Post-Assignment Account Management

After a PMCC assignment is processed, traders should promptly review their account to confirm the resolution of the positions. Brokerage firms typically provide transaction confirmations detailing the exercise of the long call and assignment of the short call. These confirmations serve as official records of the completed transactions.

The account balance will reflect the realized profit or loss from the entire PMCC strategy, including premiums paid and received, and the net effect of share acquisition and delivery. Both long and short options positions will no longer appear as open in the account, as they are closed out through assignment.

Maintaining accurate records of the trade’s outcome is important for tax purposes, as realized gains or losses will need to be reported. While specific tax rules are complex and vary, proper documentation of all transactions is essential. Reviewing the completed trade provides valuable insight into the strategy’s performance and can inform future trading decisions.