Hi Mark
I trade options by selling them and all this while I've been unaware that out of the money options could be exercised. A friend of mine recently told me that it's possible, although not probable. Is it true? I have always thought by definition, if an option is out of the money, it cannot be exercised and hence, I have always tried to let my out of the money options expire worthless as much as possible. Would greatly appreciate any kind of info you could provide. Thanks very much!
Just an addendum, I could see a scenario like this being profitable the end of the day of the last Friday before options expiration and a stock suddenly spikes after hours to be in the money…
Leo
***
Hello Leo,
Yes, it's true. The owner of an option has the right to
exercise an option at any time before it expires. The fact that it's out of the money does not
cancel that right.
Although you did not ask, when selling options, I believe that allowing options to expire worthless is far,
far riskier than many believe – especially because there is so little to
gain. Of course, if you sell options at low prices (I shudder at the
thought), then paying a few pennies to close those positions won't
work. But, if you receive a decent premium, then surely you can afford
to pay a nickel or dime to cover – especially when there are several
weeks remaining before the options expire. Why take any risk for such
small potential profits?
Getting back to your question, consider this scenario:
A market maker has a hedged position and is long 50 Jul 40 calls and short 5,000
shares. It's late in the afternoon on expiration Friday and
the stock is trading at 40.00. Our MM wants to buy 5,000 shares to
cover his short, and decides to bid 39.97. Time passes, the stock
trades as low as 39.98, but our MM buys zero shares. The stock closes
at $39.98.
The MM has two choices:
-
Do nothing, and go home for the weekend short 5,000 shares
-
Exercise those out of the money calls, and go home flat,
with zero risk
Which do you think the MM will choose? The
decision is easy. He exercises. Of course, he can try to pay $39.98
in any after hours trading before exercising. But he doesn't have much
time.
Thus, it's very reasonable for OTM options occasionally to be exercised. There is no guarantee of not being assigned an exercise notice
just because the option appears to be worthless.
As to your addendum, that's also a
risk when you allow an option that you sold to expire worthless. The problem is that most individual investors will be unaware of
that after hours spike, and will not exercise their options. Remember they
officially finished out of the money. But you can be certain that the
professional traders will be aware of the news, and exercise.
It's very simple to exercise after
hours , but the time window is short. Each broker has its own cutoff
time, but all the exerciser has to do is notify the broker "Do exercise
these options."
315
General question (unrelated to this topic)
IBM
====
Aparently IBM increased their dividend to 0.55 X May 6, Date June 9. Stock quote is 104.61. I try to see how we can take advantage of this one, if at all, using stock options:
Looking at the chart my perspective is mild bullish.
My thoughts would be:
1)sell near term Covered Calls above resistance. However there is no resistance at 110 or 115 . There is resistance is at 120 and May and June Calls do not worth much
2) Sell long term ITM Coevred Call, let’s say, Jan 2010 C 100
at about 13.10 (actually will try for a little more) .
Using this strategy, I’n getting:
1) My effective stock price is 104.60 – 13.10 = 91.50
2) Getting the dividend in about a month from now
3) Getting another quarterly dividends down the road.
4) 91.75 seems to be a support for the stock, so I do see a certain sefense on the downside.
5) If execriced I would keep not only the diviend, but also the premium of at least 13.10.
How about this?
Gil
1) Are you really doing all this just because the dividend was increased?
Would you be doing this if there were no dividend increase?
In my opinion the fact that the dividend has changed has an importance level of ZERO (on a scale of 0 to 100) when deciding whether to make this trade.
2) I guarantee that there is no way for you to take ‘advantage’ of the new dividend. Guarantee.
There are major trading firms with very expensive computers, software and traders who do nothing but look for special opportunites – especially risk free arbitrage. And they do it every second that the marekt is open. You will find nothing that someone else has not found earlier. That means if there was an edge to be had, it’s long gone.
One of the mysteries to me is why individuals are looking to ‘take advantage’ of something. I received three emails from someone yesterday looking for just such an edge. I don’t know if I convinced him that there was none and that equivalent positions truly are equivalent.
3) So we are back to the original question. Is this the covered call you want to do? If it is then do it. But I cannot believe that the dividend increase makes you like this position more today than you did earlier. The call price has already taken that dividend into consideration. I’m sure you already know that.
Also, IV has been falling steadily. Thus, if you sell a January option – an option that has substantial vega – the price is significantly less today than it was a few weeks ago. Do you believe IV will continue to decrease – then this is a good way to take advantage of that. Do you believe IV will rise again soon? If so, you would do better by writing shorter-term options.
But the biggest question of all is – do you want to invest in IBM? It sounds as if you do. I have no opinion on this play. But if your answers to the above questions tell you that it’s a good iaea, go for it.
For future reference: You cannot be ‘exercised.’ You can be ‘assigned.’