Options Expiration. A Description

Expiration is approaching, as
it does monthly.  For those who are not
familiar with the process, here is a summary of the important points for you to
understand:

  •        
    Expiration day is
    Saturday, one day after the 3rd Friday of the month.
  •       
    Stock options
    trade until the stock market closes on the 3rd Friday.  They are American style options.
  •        
    Most options on
    broad-based indexes (OEX is an exception) trade until the market closes one day
    earlier, Thursday preceding the 3rd Friday.  These are European style options
    .
  •        
    Options that
    finish in the money by one penny or more are automatically exercised.

o  
If you own one of
these options and do NOT want to exercise, you must tell your broker ‘DO NOT
EXERCISE.’  Do it as quickly as possible
after the market closes. 
If you don’t know how to notify your broker, call now to inquire.  This is important information, and when you
need it, time is short.

o  
If you sold one
of these options and have not repurchased it, you may NOT request that the
option not be exercised.  You should
expect to be assigned an exercise notice, but on occasion an option that's in
the money by only a penny or two may not be exercised by its owner.  When that happens a random selection process determines who 'slides' and is not assigned an exercise notice.

o  
American style
options settle in shares.  The owner of a ITM (in the money)
call option receives 100 shares of stock and pays
the strike price per share.  Some rookies
ask: “What happens if I don’t have enough cash to pay for the stock?”  It doesn’t matter.  The exercise occurs anyway.  If you are unable to hold the stock position,
your broker forces you to sell (or deposit more money in your account). 

The
owner of an ITM put option sells 100 shares of stock and receives the strike
price.  If you don’t own the stock, then
you sell short.  If your account is
unable to hold short stock, then you are forced to repurchase the
shares.
 

BOTTOM LINE: Be aware of these
problems in advance, and sell any ITM option you don’t want to exercise.  It’s better not to wait until the last minute
on Friday afternoon when attempting to sell.

o  
European options
settle in cash.  That makes the process
easy for you.  If you own an ITM option –
call or put – you receive its intrinsic value (the amount by which the underlying
index exceeds the strike price for a call, or is below the strike price for a
put).  Similarly, if you are short an ITM
option, the intrinsic value is removed from your account.

  •        
    To determine
    whether an option is ITM, the settlement price is used.  For stock options, the settlement price is
    the last trade on Friday afternoon.  After-hours trading DOES NOT COUNT.  For
    European style index options, the settlement price is calculated and is not a
    real-time price.  Be certain you
    understand how
    the settlement price is calculated
    because many investors find it
    confusing.
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10 Responses to Options Expiration. A Description

  1. AJ 08/14/2008 at 7:52 PM #

    Hello Mark,
    Thanks for this wonderful site. There’s a lot of useful information in here. I had a few questions regarding credit spreads. I was hoping you could answer them for me.
    Entry:
    1. How far away from options expiration do you enter a trade?
    2. What is the typical risk/reward ratio you look for?
    3. When you enter a trade, are both options out of the money?
    4. Do you make use of Greeks in your decision when you enter a trade?
    Exit:
    1. If you decide to close the position before expiration, do you close them both together or just the one that you’ve sold and let the other one ride?
    2. Do you make use of Greeks in your decision when you exit a trade?
    Thanks,
    AJ.

  2. Mark 08/14/2008 at 10:03 PM #

    Thanks for the kind words AJ.
    I am not a short-term trader and usually hold positions for 1-3 months. Please consider that when you read the reply.
    Credit Spreads:
    Entry
    When I sell a credit spread (either as a single trade or as half of an iron condor), I never sell near expiration. I know that time decay is most rapid during the last few weeks, but the negative gamma can be a fierce enemy if the underlying moves to, or through the strike price.
    I prefer 4-5 weeks as a minimum. I am also comfortable selling my spreads when two or three months remain before the options expire.
    I only sell spreads when BOTH options are out of the money.
    I don’t have a ‘typical’ risk/reward ratio. But when selling vertical spreads, I prefer to collect $1.50 to $2.00 on a 10-point spread ($3 to $4 for an iron condor). I move as far out of the money as I can to collect that minimum premium. The more time remaining, the further OTM are the options I trade. My underlying is an index, priced near 700.
    If you are trading a stock priced near $50, you cannot expect to sell the 35/45 put spread for anywhere near that amount, unless the stock is extremely volatile.
    Thus, a R/R of about 3:1 is my norm for an IC and about 5 or 6:1 for a credit spread. For many traders, that ratio is too high.
    I do NOT use Greeks as a factor on whether to enter a trade, but I am aware of the Greeks and that helps me decide on the SIZE (number of spreads) of the position.
    I use Greeks to monitor risk. Although you did not ask, I believe it’s vital to prevent large losses and risk management is an essential skill to learn.
    Exit
    I ALWAYS try to close early. I do not believe it’s in my (or anyone’s) best interest to try to collect the last few nickels on a spread.
    I ALWAYS close both parts of the spread and NEVER hang on to the long options. But that’s because I am a poor predictor of market direction and for me, owning very far OTM options is not my game. If the price were only $0.05, then yes, I’d consider holding. I know the possibility of a bonanza is available, but I’d rather take my whole profit and not gamble with part of it.
    Greeks: Greeks play no part in my decision when I’m closing early to take my profit. However, if the position is moving against me, then yes, the Greeks are important in my decision of how to deal with the pending loss. I may close all or part; I may roll to another month – but only if I love the new position. I do not stay married to a losing trade.
    I feel strongly that there is usually no ‘best’ way to trade. You will have a much better chance of being a truly successful trader when you do things that allow you to remain within your comfort zone. That means both the risk and reward of the position suit you – on a daily basis. When that zone is violated, I do something to re-enter my zone. That works for me.
    The replies I supplied suit me and my comfort zone. That does not mean it has to suit yours.
    Mark

  3. AJ 08/17/2008 at 8:30 PM #

    Hi Mark,
    Thanks for the response. I did place a couple of spread trades which did work out well. I’m just hoping that will continue. I need to learn to close the positions before expiration, because for one of them I was actually at the mercy of how the stock traded on the last day :)
    I’m sure I’ll have a few more questions for you along the way.
    Thanks,
    AJ.

  4. Mark 08/17/2008 at 9:49 PM #

    AJ,
    Glad you did well this time and more questions are welcome.
    I believe that holding European style options overnight (Thursday) is not a sound practice. I’ve seen too many (large) gap openings on settlement Friday.
    About closing early: I’m posting a two-part blog on that topic over the next two days.

  5. Mark Lewis 08/27/2008 at 8:59 PM #

    Here’s one for you. I’ve been working on a tangent idea behind the options spread: the ability to mathematically predict how your spread will do depending on where a stock goes…at expiration. So far, on paper, it’s been rock solid. The real question I have is:
    If you buy a call that is deep in the money. So deep, in fact, that people stop trading it (lik the $1 GM for Sept 2008), at expiration, what happens? Are you just out of luck? What happens if you’ve SOLD that option?
    Anyone know?
    Thanks again.

  6. Mark 08/27/2008 at 11:01 PM #

    Mark,
    When you hold an option (long or short) and expiration comes, you are never ‘out of luck.’
    If you find you cannot trade the option at a reasonable price, you can always exercise the call (per your example) and take delivery of stock at the strike price. If you prefer not to own the stock, just sell the shares. That’s better than being forced to sell the option at a price that is more than a few pennies under parity. If your strategy requires that you own a deep call option, then buy another when you sell the stock.
    If you are short the call, you will be assigned an exercise notice and sell shares short (unless you already own the shares. In that case, you simply sell them). If being short stock doesn’t work for you, you can repurchase the stock and sell a new call option.
    Mark

  7. Shawn 03/05/2011 at 3:09 PM #

    So you always close out your option spread before the experation date?

    • Mark D Wolfinger 03/05/2011 at 3:43 PM #

      Shawn,

      Yes. Always. I know that’s the right choice for me. It may not be the best choice for you – but it is the most conservative choice and a very good idea when you understand how much risk is being taken to gain so little.

      I prefer to exit about three weeks prior to expiration, but I do hold some positions longer.

      Regards

  8. Shawn 03/05/2011 at 3:12 PM #

    I’m using thinkorswim and can’t remember how to go back 45 days to purchase the options. There is anyone familiar with that on the thinkorswim platform?

    • Mark D Wolfinger 03/05/2011 at 3:44 PM #

      Shawn,
      Sorry, I am not familiar with their platform.
      Can someone help?

      Thanks

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