Tag Archives | european style options

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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Exercise and Assignment. Not to worry

The exercise/assignment process is straightforward, easy to understand, and is experienced by almost every option trader at one time or another. 

An option is a contract in which the writer (seller) promises that any buyer has the right  to buy or sell the underlying asset at the strike price on or before a specific date.

Electing to buy or sell the underlying (per the contract) is referred to as 'exercising.'  Being notified that the exercise has been assigned to your account is referred to as an 'assignment.'

Unfortunately, many new traders become overly worried about the process because they  don't bother to pay attention to the rules regarding how the process works. Why would anyone trade an option without being aware that it's possible to be assigned early?  When we drive a car, we are supposed to learn the rules of the road.  Traders who don't take the time to understand what they are trading are flying blind.

I've discussed this topic many times (here's the first), and you can search (below) for Exercise and assignment to read some of the posts.


Free put, free call

Why beginner's fear being assigned an exercise notice is beyond my comprehension.   When anyone sells an option, he/she is accepting an obligation to be assigned.  So why is it it so unsettling to be assigned one of those exercise notices prior to expiration?

Being assigned an exercise notice turns a short call option into short stock.  So what?  That exercise is equivalent to giving the option seller a free put [same strike and same expiration as the option being assigned].

Being assigned an exercise notice on a put option does cost a bit of cash (in carrying costs), but it is equivalent to being given a free call.

It's unlikely that these free options will be worth anything, but every once in awhile lightning strikes and I love  being handed those free puts and calls.  Unless it results in a margin call, being assigned early is not a problem.  If it does result in a margin call, you are probably trading too many contracts for the size of your account.

 

European and American style options

European style options cannot be exercised prior to expiration.  If you absolutely cannot tolerate being assigned early, it may pay to trade European style options.  However, there are far more important items that differ between American and European style options that it's crucial to understand these differences before attempting to trade them.  this is not an idle warning.

To read more about these differences, search (below) for American vs. European options

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Short Course in Risk Management: Two Days. Part II

Part I

One risk management tool readily available to the individual investor is the risk graph supplied by your broker.  Those graphs provide a good overall snapshot of current risk.  Along with the profit/loss graph, specific risk parameters – as measured by 'the Greeks' are available.

The Greeks provide valuable information for measuring risk.  When the trader understand potential risk of a given position, it is easier to manage that risk.  However, the Greeks are not the focus of today's discussion.

Let's take a look at a hypothetical SPX (S&P 500 Index) position, assuming that it's Tuesday of expiration week.  As a reminder, SPX options are European style and stop trading when the market closes on Thursday (one day prior to the third Friday of the month).  The final, or settlement price for the index, is calculated, based on the Friday opening price for each individual stock in the index.

Ignoring how you came to hold this position, consider:

Position.  SPX price = 1205

Long 10 SPX May 1200 calls

Short 25 SPX May 1210 calls

Long 25 SPX May 1220 calls

 Let's assume that this is a single hedged position and that you have been managing risk on that basis. [It's always tempting to break a complex position into smaller parts and manage each separately. That's for each trader to decide.  For today, this is a single position]

 

2010-04-20_1902_blog

This risk graph shows the P/L picture for the above SPX position.

The thin blue line represents risk as of today, with three trading days remaining before the options expire.  This graph looks pretty good.  If SPX declines, the loss is small, but if there's a rally, profits continuously increase as the index price moves higher.

The reason the position does so well on a rally is that the 10 extra calls (May 1200s) pick up value quickly.  The positive gamma translates into accelerating profits as SPX increases.

This position is not  all 'naked long.'  There's also the 25-lots of the short call spread (May 1210/1220) to consider.  These spreads lose value on a rally, but the gain from the 10 extra calls is enough to more than offset the loss from the 25 call spreads.


TWO days later

If you are still holding this position two days later, the risk picture has changed dramatically.  Thursday's risk graph is represented by the thick line (labeled 'think' line.  Although that's a typo, perhaps it shouldn't be).  At this point, both potential gains and potential losses are large.

Gains are essentially unlimited on the upside, but there is a barrier between you and those big gains.  If SPX settles (reminder, you will not know that settlement price until midway through the trading day on expiration Friday) in the vicinity of 1220, losses mount quickly.  The protection you owned on Tuesday has disappeared.

A rally places you in a big bind.  If the rally is BIG, you win.  If it stalls near 1220, you lose, BIG.  For most traders this is not a reasonable risk/reward scenario.  Everyone loves collecting theta as expiration nears, but that requires holding positions with negative gamma.  Thus, sometimes there's a big price to be paid to offset all those times when theta collection proves to be the winning choice.

This is too risky for me, but only you an decide whether it suits you and your comfort zone.   I urge you not to trade expiration week – at least not until you consider yourself to be experienced and able to handle risky positions with skill.  Closing your eyes and hoping they turn out well is not the skill set I have in mind.

The main point of this discussion is not taking today's risk graph at face value.  You must be aware of the effects of time an your overall risk.  A few days may seem insignificant – and it is when trading LEAPS options, but it plays a huge role when holding positions during expiration week.

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RookiesCover

"It is truly amazing how much I have
learned by reading your book.  I had shied away from trading options
because I thought they were too risky for a casual investor who did not have
formal training."

DE



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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.


OptionsZone_logo

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)

***

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…

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