A few days ago, Knight Capital Group (KCG) had a self-proclaimed “rogue algorithm” take off and push prices around on certain high-volume equities. We had a few questions about what this means for retail traders, and options traders in general, and wanted to address it for a moment.
For the most part, quick swings like this don’t affect those traders who are holding longer-term positions. The movement is so quick, and the ranges affected so small relative to long-term moves, that it’s rarely consequential - just a blip in price action over a long period of time. Now, if you were long KCG you don’t feel that way, but for the rest of us, it wasn’t a big issue.
For options traders, the risk posed by quick fluctuation is the risk of assignment in certain positions, particularly if these swings happen very close to expiration. In general, it doesn’t make sense to exercise options early because the person holding the contract forfeits any time value in the options upon exercise. Unless the options are very deep in the money, this usually isn’t worth it. However, some prices can swing to the point that options become deep-in-the-money for a short time, and this presents a risk. Unfortunately, it’s not one that can be avoided with hedging, unless you’re closely following prices and notice the same spike.
Since our trading strategy is about “setting it and forgetting it” with many of our trades, it’s unlikely you’d see a very short-term chance like that. The good news is, depending on the maintenance requirements of your broker, getting assigned on the short option in a vertical spread (either debit or credit) is actually the best thing that can happen to you. As we said above, that person who chooses to exercise forfeits their time value in the option - and this directly benefits you, the person who sold the option and gets to “keep” the time value. Your risk hasn’t increased at all, since the resulting stock position after the exercise will have the same directional bias as the short option did, and you’ve still got your long option to hedge the position. In fact, what will happen is this - you’ll go from a “limited gain/limited risk” position to an “unlimited gain/limited risk” position, where the risk is exactly the same. Not a bad deal!
Bottom Line: Don’t be afraid to trade, but instead, understand the risks you take and the situations in which you can profit and loss. Take control, and have no fear!