Q and A. Can OTM Options Be Exercised?

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

9 Responses to Q and A. Can OTM Options Be Exercised?

  1. Gil 05/02/2009 at 11:34 AM #

    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

  2. Mark Wolfinger 05/02/2009 at 1:39 PM #

    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.’

  3. Dmitry 08/16/2012 at 9:53 AM #

    Hi Mark,

    I am complete newbie and my question is probably very stupid. I am trying to understand the mechanics. Let’s say I wrote one call at 115 with expiration a month away, the stock trades at 100. If buyer of my option exercises it right now (regardless of illogical and bad outcome for the buyer), does it mean that I have to go buy 100 shares of that stock at the current market price of 100 and sell it to him for 115? What if I don’t have enough money in the account?

    Thank you for your time,

    Dmitry

    • Mark D Wolfinger 08/16/2012 at 10:15 AM #

      Dmitry,

      No question is stupid. In fact, this is a GOOD question.

      It sounds as if you want to sell a NAKED call (that means you do not already have he 1200 shares in your account).

      1) Most brokers will not allow you to sell an naked call because they consider it to be too risky – especially for a person who is new to options.

      2) NO. You do not have to buy 100 shares right now. You do have to SELL 100 shares at $115.

      But you will be short 100 shares of stock if you do not’ go buy’ those 100 shares now. If you want to own a short stock position, if your account has been given permission to carry a short stock position,and if you can meet the margin requirement, then you do not have to do anything. It is risky to be short stock, but you may do so.

      3) If you do not have enough cash in your account, then you get a margin call and MUST go buy the 100 shares immediately. In fact, it is possible that your broker would buy them for you – without asking your permission.

      You are welcome.

      • Dmitry 08/16/2012 at 10:37 AM #

        Hi Mark,

        Thank you for the fast reply. It is still not clear to me. Lets use the concrete example. I have $15,000 in my account. If I sell 1 NOV naked OTM option at $115 strike and volatility 52% on a stock that trades at $102 right now (LNKD), I receive a premium of $520 and a maintenance margin of ~$2,200 (interactive brokers). $7,000 in my account is tied in shares of 3 other companies.

        If counter-party buyer assigns me those shares right now by pressing the wrong button or whatnot, I will have to sell it to him at $115 and make a gain of $13 per share or $1,300. Because I don’t have those shares, I will have to go buy them at $102? The amount is $10,200 and is more than $8,000 available in my account. What happens here, the broker just credits the profit or does the broker have to go through the actual process of buying those shares and then selling them? In this case, will broker lend me the money I am lacking?

        Best regards,

        Dmitry

        • Mark D Wolfinger 08/16/2012 at 3:44 PM #

          Dmitry,

          You found the broker who does allow ANYONE to sell naked call options.

          Yes. You would sell at 115. Yes you would earn a profit of $115 minus the price you pay for the stock. Right now that appears to be $102, for a gain of $13 per share.

          Yes, you would want to buy the shares at $102. But you are not OBLIGATED to do so. You are allowed to remain short stock (if you can meet margin – but in this example you do not have sufficient assets).

          You do not have to borrow any money from the broker. You sell stock at 115. You collect that cash when the stock settles. If you receive that exercise notice tomorrow (Friday), then the $11,500 cash shows up in your account on Wed. You cannot just use this cash because it comes from a short sale, but it is in the account and is available to buy shares to cover the short. If you buy stock Monday, that trade settles Thursday and that is when $10,200 cash is needed to pay for the shares. You already have that cash from the short sale. You would be left with approximately $1,300 after you sell, and then buy the shares.

          Understand this: When you are assigned an exercise notice – that is a transaction. It means you already sold stock. So the broker is not going to make another transaction. You are now short the shares. After you buy the shares, you no longer have a position. There are two fees involved: The assignment fee (which is ZERO at Interactive Brokers), and the commission to buy stock.

          • Dmitry 08/20/2012 at 10:02 AM #

            Hi Mark,

            Thank you very much for the detailed explanation. It is clear now. I somehow did not get an email notification on your second reply. I have been with interactive brokers for six years and I am very happy with them, they are excellent cost-wise and have widest range of products.

            Good luck in your endeavors,

            Dmitry

          • Mark D Wolfinger 08/20/2012 at 11:01 AM #

            Dmitry,

            I do not send e-mail notifications.
            I did it for you – because I wanted to be certain that you received the reply.

            Good trading

  4. bryan 01/11/2013 at 4:59 PM #

    Thank you for this post. I just watched Apple close at 520.30, and was wondering why the 525 option still has a bid price of .01 and an ask price of .02

    The options cease trading at 3:00.
    That one penny bid is by anyone who is afraid that the stock could jump 5+ points in after hours trading.
    It is not likely that the stock would jump, but for $1 (plus commissions) the ultra-conservative player would want to cover that short.

    In my opinion, that short should have been covered earlier, but that is the only reason I can think of as to why there would be a bid right up to the closing bell.
    Notice that there were no sellers.