<I>TSC</I> Options Forum: The Cost of Assignment

Dear Steve:

Thanks so much for your excellent writings. I find it extremely unfair that brokerages charge separate commissions when options get assigned by partial allotments. If I wrote out 10 contracts, in theory it could be assigned 10 times and I'd have to pay 10 commissions. Is this practice legal, legitimate or ethical?

-- S.W.

Unfortunately, separate charges incurred through partial assignments are legal, legitimate and (admittedly, I didn't poll every brokerage firm out there) seem to be a uniformly accepted industry practice. But the good news is that you should rarely experience the pain of multiple commission costs on a single position.

While most equity options are American-style, meaning they can be exercised at any time before expiration, less then 2% of all assignments occur more than two days prior to expiration. And of those that do, a good portion are due to dividend arbitrage, meaning they are one-day events.

A distinction needs to be made between assignments done in a single day (but in multiple-lot fashion) and a series of partial assignments that take place over several days. Even though it's not uncommon for an option assignment -- even on a 10-contract position -- to be broken down into several small pieces (for more on the random nature of the option assignment allocation process, click here), as long as they all occur on the same day, only one single commission fee will be charged.

According to Ned Bennett, CEO of online brokerage firm OptionsXpress, "the nature and economics of the assignment and trade-clearing process means that transactions on separate days will unfortunately cause us to charge new commissions due to the additional paperwork and associated fees." Bennett added that most clients "know if they will be assigned on the day of expiration, and they can either choose to hold the stock position long or short, or simply cover the option in order to avoid a double commission" incurred through an assignment and then having to execute an offsetting trade in the underlying equity. But again, most option assignments are single-day events that will incur only a single commission.

Steve:

I am sure you get this question all the time, but this is new to me. I want to start investing in the stock market (beyond my 401(k)). Most of the advice I've received is to start not with options, but to invest in mutual funds or maybe stocks to get my feet wet. Would you give the same advice, or can a rookie investor start trading options (after being educated in their proper use)?

Thanks for your time,

-- J.

You won't find me bad-mouthing mutual funds; they've received enough abuse over the last few months. I'll add, however, that less than half of them actually outperform their benchmarks, so if you simply want market exposure, I'd suggest sticking with a low-cost index fund or exchange-traded fund such as the S&P Depositary Receipts ( SPY).

My job, of course, is to proselytize for using options. With that bias disclosure out of the way, I'd say you can definitely build a stock portfolio using options.

Without giving specific recommendations, I can offer a few guidelines and point out the benefits and drawbacks for using options as an investment vehicle. Note that I'm using the word "investment" rather than "trading" because until you are completely comfortable with options trading and willing to make the markets a full-time occupation, you should keep a reasonably long time horizon. That means you should focus on long-dated options or LEAPs, which have at least nine months to a year (even up to two years) remaining until expiration, allowing time for your investment thesis to play out.

Initially, I'd stick with simply buying at-the-money options, whether they be puts or calls, to create an options-based stock portfolio. The main advantage of using options over buying (or shorting) the actual shares of the underlying stock is the lower cost and reduced risk. For example, with Procter & Gamble ( PG) trading at $103 on Friday, you could buy the January 2006 call with a $100 strike price for $11.50 a contract. This means one call, which represents 100 shares, costs $1,150 and represents your maximum loss or risk.

On the other hand, buying 100 shares of P&G would require a capital outlay of $10,300, or $5,150 assuming a 50% margin, and taking on the commensurately greater risk should the stock suffer a steep decline.

The two main drawbacks to building a portfolio with options are 1) the option premium creates a higher break-even point (in our P&G example it's $111.50, or $8.50 above the current stock price), and 2) a call option owner, unlike owning the actual shares, isn't entitled to collect dividends.

For more on options and the nature of LEAPs, see this article.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

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