Options Expiration. Six Things to Know, Before you Play the Game. Part II

Over at the Options Zone, this post
(slightly edited) was published
on April 14, 2010.

OptionsZone_logo

Part I

3) Do not fear an assignment notice

If you are assigned an exercise
notice on an option you sold, that is nothing to fear, assuming you are
prepared.  By that I mean, as long as the assignment does not result in a
margin cal.

Many novices are truly fear receiving
an assignment notice.  It's as if they believe 'something bad has
happened.  I don't know what it is, nor do I know why it's bad.'

Being assigned prior to expiration is
usually beneficial from a risk-reduction perspective.  More on this
topic at another time.  


4) European options are different

Most options are American style
options and all the rules you already know apply to them.  However, some
options are European style (no, they do not trade only in Europe), and
it's very important to know the differences, if you trade these options.

Most index options are European
style:  SPX,
NDX, RUT (not OEX).  These are index options and not ETF (exchange
traded fund options).  Thus, SPY, QQQQ, IWM are all American style
options.

a) These options
cease trading when the Market closes Thursday, one day prior to
'regular' options expiration day.

b) The final 'settlement' price – the
price that determines which
options are in the money, and by how much – is calculated early in the
trading day on Friday, but it's not made available until approximately
halfway through the trading day. 

The settlement price is NOT a real
world price.  Thus, when you observe an index price early Friday
morning, do not believe that the settlement price will be anywhere near
that price.  It may be near, and it may be very different.  
It is calculated as if each stock in the index were trading at its
opening price – all at the same time.  Be careful.  Often this price is
significantly higher or lower than traders suspect it will be – and that
results in cries of anguish from anyone still holding positions.  It's
safest to exit positions in Europeans options no later than Thursday
afternoon.

c) European options
settle in cash.  That
means no shares exchange hands.  If you are short an option whose
settlement price is in the money, the cash value of that option is
removed from your account.  If you own such options, the cash value is
transferred to your account.


5) Don't hold a position to the bitter end

It's not easy to let go.  You paid a
decent premium for those options and now they are down to half that
price.
That's not the point.  You
bought those options for a reason.  The only question to answer is
this:  Does that reason still apply?  Do you still anticipate the stock
move you had hoped would happen?  Has the news been announced?

If there is no good reason to hold,
cut your losses and sell out those options before that fade to zero.

Is the shoe on the other foot?  Did
you sell that option, or spread, at a good price and then see the
premium erode and your account balance rise?  Is that short position
priced near zero?  What are you waiting for?  Is there enough remaining
reward to hold onto the position, and with it, the risk?  Let some other
hero have those last couple of nickels.  Don't take big risk unless
there's a big reward.  Holding out for expiration – especially when it's
weeks away is not a good plan.


6) Negative gamma is not your
friend

When you are short options, you are
short gamma.  Most of the time that's not a problem.  You get paid a
nice rate of time decay to hold onto a short position – reducing risk
when necessary.  But show some respect.  Negative gamma is the big, bad
enemy. When the reward is small, respect this guy and get outta town. 
Cover those negative gamma shorts, take you good-sized profit and don't
bother with the crumbs.


Options expire monthly.  It's important to understand the risks and rewards associated with trading options as expiration day approaches.

667


Expiring Monthly: The Option Traders Journal

Small_logo

Vol 1 No 2 published today

Subscribe

, , , ,

5 Responses to Options Expiration. Six Things to Know, Before you Play the Game. Part II

  1. 5teve 04/19/2010 at 10:09 AM #

    Hi, Mark
    1)In the chapter of Equivalent Positions, (Example of Page 137 of Rookies’ guide to options) you mentioned a collar is equivalent to a put spread (which is ITM). my question is will two positions have exactly the same profit or loss? I have little difficulty seeing that.
    2)Will the following position work? Do you consider them as a strategy?
    a)Having a collar reversely: short underlying, sell a put, and buy a call.(Is there a name to this “reverse collar” or it is a collar also?)
    b) a position that contains both a collar and “reverse collar” at a same underlying and expiration.(is it equivalent to CTM iron condor?-_-!)
    Thanks

  2. Mark Wolfinger 04/19/2010 at 11:05 AM #

    Hello 5teve,
    1) Owning a collar is equivalent to selling a put spread. But – the strike prices and expiration date are the same.
    2) EXACTLY the same P/L? Not quite. But the answer to your question is yes. Taking all expenses into consideration – including the fact that the collar owner gets any dividends and pays interest to own stock (instead of investing that cash).
    There may be a difference of a couple of pennies because of the way options are priced. By that mean that prices are usually priced every nickel, even though penny pricing is allowed.
    I know it may be difficult to see, but the ‘proof’ is printed in the book. That ought to convince you.
    If not, take pencil and paper and do all the arithmetic and see the results. DO NOT use ‘last’ prices for option prices. Use bid/ask midpoints.
    2) Yes, it’s a strategy.
    a) But why bother? It’s equivalent to buying a put spread.
    Short stock and long call is buying a put. Thus, the position is buying one put and selling another.
    b) Long a collar is short a put spread.
    Short a collar (your ‘reverse collar’) is long a put spread.
    Thus, it’s a condor. And yes, that’s equivalent to an iron condor – with same strikes.
    Is that understandable?

  3. 5teve 04/19/2010 at 11:31 AM #

    Hi, Mark
    Thanks for the answer. It is much clear to me now.

  4. John 04/19/2010 at 12:13 PM #

    Hi Mark,
    Do you find it easy to get a good fill when closing a vertical spread (almost fully ITM) by posting a buy between the bid-ask spread? I have tried with stock and found it difficult to get a good fill. How about index, like RUT?
    Thanks.

  5. Mark Wolfinger 04/19/2010 at 1:18 PM #

    Hey John,
    A ‘good’ fill is in the eyes of the trader. By my definition, a good fill occurs under two circumstances:
    a) I get filled at 10 cents worse than the bid/ask midpoints
    b) I get filled at my limit – but that happens because the market moved and my offer became attractive
    But when almost fully ITM, it’s almost impossible to get a ‘good’ fill. Why would anyone want to pay $9.90 when all they can earn is a dime? Who would take that risk?
    It’s no different in an index. Why would you expect anyone to be willing to take the other side? You must make it attractive and offer the spread at a price that may attract a buyer.
    The best way to ‘exit’ this spread is to try to buy the corresponding put spread. That would give you a box spread. The trouble with that contraption (when trading American style options) is pin risk at expiration.
    Just accept that getting out of spreads at near the maximum value prior to expiration is difficult, at best.
    Regards