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

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


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Options expiration.  When you sell options, it's an anticipated event.  When you own options, it's something to dread.

At least that's how most people view it.  There's much more to an options expiration, and if you are a newcomer to the options world, there are things you must know and steps you should take to avoid unpleasant surprises.  However, if you enjoy nightmares, feel free to disregard this entire post.

Many investors come to the options world with little investing background.  they consider the 'options game' to be simple:  You buy a mini-lottery ticket.  Then you win or you don't.  I have to admit – that's pretty simple.  It's also a quick path to losing your entire investment account.

It's important to have a fundamental understanding of how options work before venturing onto the field of play.  But not everyone cares.  It you are someone who prefers to keep his/her money, and perhaps earn more, then those option basics are a must for you.

No one takes a car onto the highway the
very first time they get behind the wheel, but there is something about
options, and investing in general, that makes people believe it's a
simple game.  They become eager to play despite lack of training.

Today's post provides some pointers for handling an options expiration.  Options have a limited lifetime and the expiration date is always known when options are bought and sold.  For our purposes assume that options expire shortly after the close of trading on the 3rd Friday of every month. (Expiration is the following morning, but that's just a technicality as far as we are concerned)

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Please don't get caught in any of these expiration traps.

1) Avoid a margin call 

New traders, especially those with small accounts, like the idea of buying options.  The problem is that they often don't understand the rules of the game, and 'forget' to sell those options prior to expiration. If a trader owns 5 Apr 40 calls, makes no effort to sell them, and decides to allow the options to expire worthless, that's fine.  No problem.  However, if the investor is not paying attention and the stock closes at $40.02 on expiration Friday, that trader is going to own 500 shares of stock.  The options are automatically exercised (unless you specifically tell your broker not to exercise) whenever the option is in the money by one penny or more, when the market closes on that Friday.

In my opinion, this automatic exercise 'rule' is just another method that brokers use to trap their customers into paying unnecessary commissions and fees.

On Monday morning, along with those shares comes the margin call.  Those small account holders did not know they were going to be buying stock, don't have enough cash to pay for the stock – even with 50% margin – and are forced to sell the stock.  Rack up more costs for the investor and more profits for the broker.  Please don't forget to sell (at least enter an order to sell) any options you own. 


2) Don't exercise

If you own any options, don't even consider
exercising.  You may not have the margin call problem described above, but did you buy options to make a profit if the stock moved higher?  Or did you buy call options so that you could own stock at a later date?  Unless you are adopting a stock and option strategy (such as writing covered calls), when you buy options, it's generally most efficient to avoid stock ownership.  Here's why.

If you really want to own stock, when buying options you must plan in advance, or you will be throwing money into the trash.  For most individual investors – at least inexperienced investors – buying options is not the best way to attain ownership of the shares.

If the stock prices moves higher by enough to offset the premium you paid to own the option, you have a profit.  But, regardless of whether your investment has paid off, it seldom pays for anyone to buy options with the intention of owning shares at a later date.  Sure there are exceptions, but in general: Don't exercise options.  Sell those options when you no longer want to own them.

Example: Here's the fallacy.  The stock is 38, you buy 10 calls struck at 40, paying $0.50 apiece.  Sure enough you are right.  The stock rallies to 42 by the time expiration arrives.  You know a bargain when you see one, and exercise the calls, in effect paying $40.50 per share when the stock is worth $42.  This appears to be a good trade.  You earned $150 per option, or $1,500.

Before you congratulate yourself on making such a good trade, consider this: The truth is that you should have bought stock, paying $38.  If you are of the mindset that owning shares is what you want to do, then buying options is not for you.  And that's even more true when buying OTM options.

If you are an option trader, then trade options.  When expiration arrives (or sooner) sell those calls and take your profit (or loss).  There's nothing to be gained by exercising call options to buy stock.  Why pay cash for an option, then hope the stock rises so that you can pay a higher price for stock?  Just buy stock now.  If you lack the cash, but will have it later, that's the single exception to this rule.

If this exception applies to you and you are investor, not a trader, then buying the Apr 40 calls is still the wrong approach.   Buy in the money calls – perhaps the Apr 35s.  You might pay $3.60 for those calls.  If you do eventually take possession of the shares, the cost becomes $38.60 (the $35 strike price plus the $3.60 premium) and not $40.50.  Buying OTM options is not for the investor.

to be continued…

666


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10 Responses to Options Expiration. Six Things to Know, Before you Play the Game

  1. Henry Tzuo 04/17/2010 at 9:39 PM #

    Hey, it’s cool Mark. Look forward to the following!!!
    Henry Tzuo

  2. Henry Tzuo 04/17/2010 at 9:52 PM #

    Hi mark:
    I have read the entire post. About the ” excercise notice” thing, I am very curious about one thing:
    If, I sold a time spread (the same exercise price, NOT a diagnol spread) , that is, sell next month and buy current month, and that position became in the money, so, I got an ” exercise notice” from my short position.
    May I, also send an “exercise notice”, on my long position,
    to let the 2 positions settle automatically???
    I am afraid of a “time difference” between I receive my shares and I pay my shares. Even if I send out my ecercise notice immediately when I receive one, do I still face the “time gap” risk???
    Thanks in advance. I only traded European ops before. I am a newcomer to American ops.
    Henry Tzuo

  3. Mark Wolfinger 04/17/2010 at 10:51 PM #

    Henry,
    European style options have some decent advantages, and not being assigned before expiration is one of them
    1) Yes, you may exercise your long options AT ANY TIME prior to expiration.
    It does not matter whether the option you were short has been exercised. Nothing matters. You may exercise at any time.
    2) Yes, there is a one today time ‘gap’ but do not let that bother you.
    a) Assignments are handed out only once per day. That is at night, after the markets have closed for the day.
    b) You cannot send out an exercise notice ‘immediately.’ You may exercise your options at any time, and the exercise is irrevocable – so in effect you ‘sent’ it immediately. But that makes no difference..
    Your notice is officially ‘sent’ after the market closes for the day. There are many reasons why that is true.
    c) So if you receive an assignment notice one morning and immediately exercise, you will own the stock position resulting from your assignment notice (short stock if these are calls and long stock if they are puts) for one day BEFORE your exercise notice settles and offsets the previous assignment.
    d) Unless this stock pays a large dividend, there is almost zero chance this will happen to you. No one who knows what he is doing exercises a call option any earlier than necessary – and that’s when expiration arrives.
    Deep ITM put options may be assigned early. But with today’s very low interest rates, that’s not common.
    e) If this did occur, you would earn the maximum possible profit on the call spread because you would be buying it back at zero debit.

  4. Henry Tzuo 04/18/2010 at 6:37 AM #

    Hi Mark:
    Thanks for the detailed illustration. Gotcha!!!
    Have a great weekend!!!
    Henry Tzuo

  5. Josh 04/18/2010 at 5:52 PM #

    Hi Mark,
    I have an off-topic question, but couldn’t find an email link so sorry in advance.
    What happens when a stock is aquired by another company? Would love to know for all situations of being long or short puts and calls if that’s not asking too much.
    On a slightly more ominous note, is this the 666th post?
    Josh

  6. Mark Wolfinger 04/19/2010 at 7:20 AM #

    Josh,
    Off topic is fine. No problem.
    Yes, post # 666
    See this post
    Short reply: After a takeover, essentially nothing happens. If you own an option, you had the right to buy or sell 100 shares at the strike price. Ex: strike price 40, you pay or collect $4,000 for 100 shares.
    Now you own the right to buy or sell – at that old strike price ($4,000) whatever it is that the owner of 100 shares got in the merger. You may have the right to buy 54 shares of stock in the acquiring company stock; or perhaps it cash plus some shares; or perhaps it’s cash, plus shares, and bonds.
    You still get exactly what you would have gotten (or sold) by paying (collecting) that $4,000 – as any shareholder got in the merger transaction.
    The CBOE always publishes complete details. GOOGLE the company game + merger, or the old option symbol. You’ll find it.

  7. scott 04/19/2010 at 10:51 AM #

    Mark,
    In my last post I explained how I am in my second month of trading spreads. I also explained that for this month I entered the Call side first and entered the put side Friday. As you continue to point out, the key to being successful in these spreads is how you adjust (or NOT adjust) not just whether you make or lose money. At this point, I could exit my my call side (these are May index options)for about a 60% of max profit. If I exited my put side I would probably lose most of that profit, and have a slight gain from the whole transaction. My Delta on my puts are about .06 so I am not in ank risk at this point. How would you normally handle this situation? There are many “options” I see, but most likely are:
    1. Close all positions, take a small gain
    2. Close the Calls for a 60% max profit and either a) sell a new call spread to try and bring in more premium; or b) do not sell a new call spread and wait and watch the put spread;
    3. Do Nothing

  8. Mark Wolfinger 04/19/2010 at 12:42 PM #

    Scott,
    Replied as a separate post.

  9. Nilesh 07/31/2014 at 5:18 AM #

    what are the charges applied if I forget to sell my option after buying it before expiry?

    • Mark Wolfinger 07/31/2014 at 8:18 AM #

      When your option is out-of-the-money, there are no charges. It just expires worthless.

      When the option is in-the-money, you are charged an “assignment fee” that varies from broker to broker. The fee can range from zero to approximately $20. It is probably much higher for a full service broker (Merrill Lynch, for example).