A very common question regarding Deep ITM (In The Money) Debit Spreads arises when upcoming dividends are announced. Traders short ITM options approaching the ex-dividend date are vulnerable to potential assignment which triggers the liability of owing the dividend due. So what do you do if you find yourself in this situation?
First, look-up the latest quote price of your short option strike. If the extrinsic value of the option is greater than the dividend amount, then you have a very low probability of being assigned and therefore, owing the dividend. Extrinsic premium is the portion of the option's value (price) that is OTM (Out of The Money) and can be calculated easily:
Underlying stock price less the ITM short strike less the last quote price of the ITM short strike = extrinsic value
Here is a real life example: SPY closing price of 122.18, Short strike of 121 with a last price of $2.50. Utilizing the equation above looks like:
$122.18 - $121 - $2.50 = $1.32 extrinsic value
The above example's upcoming SPY dividend is quoted as $0.70. The extrinsic value is calculated as $0.62 [$1.32 - $0.70], substantially more than the dividend. Therefore, exercisers requesting payment of the dividend, resulting in assignment of the short option to the seller, would actually lose money as they would receive only the dividend and would miss out on the remaining $0.62 of premium.
In a situation like this, I usually leave the option position open as the probability of being assigned is minimal; no more probable than being assigned at any other time. Remember: short options can technically be assigned at anytime. The smaller the extrinsic value the more likely the option is to be assigned and therefore, should be closed to eliminate dividend exposure.
Navigate wisely and stay profitable, my friends. Happy trading!
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