Considerations when Managing Risk III. Expiration day

Holding positions into expiration

For traders who frequently adopt the so-called ‘income’ option strategies, the passage of time is friendly and large market moves are the enemy.

Because each passing day bring additional theoretical profits – if the market behaves – it is difficult for some traders to exit before the very last penny has been earned. I have expressed my feelings about the greediness and riskiness of holding to the end (too much risk for too little reward), but there are other considerations worth mentioning.

Please understand that holding options and waiting for them to expire worthless is unrelated to the ideas of actively trading options on expiration day. Jeff Augen’s book [Trading Options at Expiration] offers advice on how to trade expiration day – and that has nothing to do with holding and waiting for options to become worthless.

Holding A.M. settled, European style, options into settlement

Most options expire at the end of trading on a given day – and that is most often the 3rd Friday of the calendar month. There are exceptions:

  • Weeklys
  • Quarterlies
  • VIX options
  • Morning settled European style index options

The one factor to take into consideration when dealing with morning settled European options is the manner in which the ‘final closing price’ or settlement price is determined. It is not a real world price. It is a fictional price calculated on the following:

  • Use the opening price for each stock in the index, regardless of when it opens
  • Assume that each stock is trading at its opening price simultaneously
  • Calculate a value for the index based on the two items above

That methodology may feel reasonably accurate and it may seem as if it represents a real world price. When markets are calm, all assumptions are true. The price is reasonable.

However, there is a lot of risk associated with holding positions (long or short) into that settlement. Consider a bear market, although it works the same way in a bull market. At the opening, thee are many sellers. Some stocks open quickly while others are delayed due to an order imbalance.

Let’s assume that half the stocks open, the published index price is lower, and that those who held positions see the opening stock for the index and walk away, believing they know where the index will settle. Here’s the real problem. Many times, the market has opened at a low,due to selling pressure. The market comes off the bottom and the index begins to rise. However, there are all of those stocks that have not yet opened. There is still the original sell imbalance in those stocks and they eventually open lower, adding more negative impact to the index. However, that impact is not displayed becasue there is now enough support for stocks that opened earlier to keep the published index price from falling.

Bottom line: The settlement price is based on low ticks from 9:30 ET, even though many of those stacks are already trading higher when other stocks open at a relatively low price (the order imbalance often does not disappear until after the opening). None of the published, real-time prices for the daily index comes close to the very bearish final settlement price. When that price is finally published (end of day, or 1PM ET for SET – the settlement price for the SPX index) it may be FAR lower than the published low for the day.

Settlement prices can bring an unwanted surprise. It’s far safer to exit options no later than Thursday afternoon of expiration week.

My bottom line: There is always danger than an OTM option can move ITM. In this blogger’s opinion, it’s foolish to risk a decent chunk of money in an effort to earn that final nickel or dime from a short option position. Others believe that covering these shorts is a complete waste of money. All I can tell you is that in my experience, covering is well worth the cash cost.

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6 Responses to Considerations when Managing Risk III. Expiration day

  1. Jeff 04/20/2011 at 6:27 AM #

    The concluding sentence is indicative of the overall frustratingly (is that a word?) subjective nature of this post. There is substantial quantitative research extant that helps us make informed decisions in this regard — if we do our homework.

    • Mark D Wolfinger 04/20/2011 at 8:12 AM #

      Hello Jeff,

      Much of what I blog about represents my opinion, or ‘bias’ if you prefer that word. I offer my point of view, but never suggest that is the only point of view.

      I am comfortable exiting when I’ve earned $2.50 out of a maximum $2.70 – regardless of the probability of earning all or part of that last 20 cents. Even if I knew that covering was the losing decision 98% of the time, I know that the psychological hurt that I would feel when an inevitable large loss occurred is well all it worth avoiding. Call it sleep-at-night insurance or medication. It comes with a financial cost.

      Thanks.

  2. rick f. 04/20/2011 at 10:57 PM #

    Agree with Mark’s comments. As I posted elsewhere the other day, I tend to close out my expiring positions on (usually) Wed or (no later than) Thursday noon of expiration week, just to avoid any hiccups resulting from political, economic, technical, idiotic causes in the world.

    When I’m short options, having a broker that lets you buy back short options at .05 (or less) for free helps manage some of that risk, even on options that are “so far OTM there’s nooooo chance they’ll be in danger” — better safe than sorry!

    But yes, I don’t hold out for that last dime or nickel … when time isn’t on your side, and you’re nicely profitable, in my view, the trade’s a win. I won’t get greedy.

    My own opinion. 🙂

    • Mark D Wolfinger 04/21/2011 at 7:51 AM #

      Rick,

      This is an individual decision, but long-term survival suggests prudence.

  3. Howe 04/25/2011 at 11:10 PM #

    Hi Mark,

    Stock options do NOT expire the third Friday of the month of their expiration. They actually expire the third Saturday of the month of expiration, but for trading purposes people usually state that they expire on Friday (since the market is not open on Saturday).

    That’s my rule too. I always close out your positions at least 3 days before expiration. No.1 we never “IF” the far OTM options becomes ITM. No.2 there might not be volume for you to close your positions on the last day of expiration, (rare but still might have a chance) No.3 Profit is profit, treat that $0.20 as a hedge on your profit and not as $0.20 loss. In this way, your psychology won’t take a beating.

    My own opinion. 😀

    • Mark D Wolfinger 04/26/2011 at 7:26 AM #

      Howe,
      I repeatedly state that options expire on Saturday, following the 3rd Friday. This time I failed to do so. The reason: Most traders don’t care. Much of what happens via he OCC is crucial to the exercise/assignment process, but it does not affect traders. For example, most believe that ‘the broker exercises the options.’ Most have no idea of how an account is chosen to receive an exercise notice.

      I believe these are important items to understand, but it’s a fine line between not mentioning them and going through the same expiration many times.

      However, I do appreciate your paying attention to the details.

      I have never seen a single example for which there is not enough volume to exit a trade – unless there is no one willing to pay even one cent to but the option being offered. Not saying it’s impossible, but I’ve never seen it.

      Regards