This post was first published on Nov 16, 2010 at InvestorPlace.
Unless buying or selling options with a distant expiration date (LEAPS), each trader understands that the value of an option portfolio becomes increasingly volatile as the time to expiration decreases. I is important to be aware of specific situations that may crush (or expand) the value of your positions.
Here are six situations that should be of special concern when expiration day draws nigh.
1) Position Size
When trading options, the most effective method for controlling risk is paying attention to position size (number of options or spreads bought/sold). Smaller size translates into less profit and less reward. However, successful traders understand: minimizing losses is the key to success.
When expiration approaches, an option's value can change dramatically. The effect of time is far less on longer-term options.
Gamma measures the rate at which an option's delta changes. When gamma is high – and it increases as expiration approaches – delta can move from near zero (OTM option) to almost 100 (ITM option) quickly.
Option owners can earn a bunch of money in a hurry, and option shorts can get hammered. However, those short-lived options often become worthless. These are the conflicting dreams of option sellers and buyers.
The point is that having a position in ATM (or not far OTM) options is treacherous, and reducing the size of your position is a healthy and simple method for reducing risk.
Consider reducing position size when playing the higher risk/higher reward game of trading near expiration.
2) Margin Calls
Receiving an unexpected margin call is one of those unpleasant experiences that traders must avoid. At best, margin calls are inconvenient. Most margin calls result in a monetary loss, even if it's only from extra commissions. Think of it as punishment for not being prepared
When you hold any ITM short option position, there is the possibility of being assigned (and converting an option position to stock) an exercise notice. Early exercise is unlikely unless the option is deep ITM. However, you already know that any option that finishes ITM is subject to automatic exercise.
Exiting the trade prior to expiration makes it likely (there is still the chance of being assigned before you exit) that you can avoid the margin call.
Most put sellers (conservatively) sell puts only when cash secured. That means: cash to buy shares is already in the account. When cash is available, there is no margin call.
Those who write call options are subject to the same assignment risk. If the trader is covered, there is no problem. Upon assignment, the shares already owned are sold to honor the option seller's obligations.
When you receive a margin call, many brokers (no warning) sell enough securities (to generate cash) to meet that call. Other brokers automatically repurchase your short options (with no advance warning) before expiration arrives.
Bottom line: When you cannot meet the margin requirement, do not hold a position that is subject to early exercise. And never hold that position through expiration (when assignment is guaranteed). Find a way to exit the trade to avoid possible margin calls. For clarity: If margin is not a problem, none of this applies to you.
3) Increased Volatility
Pay attention to volatility – both volatility of the underlying stock or index as well as the implied volatility of the options themselves.
For option owners volatility is your friend. The fact that stocks are more volatile is enough to raise implied volatility, and that in turn increases the value of your options – sometimes by more than its daily time decay.
If you get lucky twice, and the volatile market moves your way, the option's price may increase many-fold. That's nirvana for option owners.
However, if you are looking at increased market volatility from the perspective of an option seller, volatility translates into fear. Whether a trader has naked short options (essentially unlimited risk) or short spreads (limited loss potential), he/she must recognize that the market (the underlying asset) can undergo a large, rapid price change.
Options that seemed safely out of the money and a 'sure thing' to expire worthless are suddenly in the money and trading at hundreds (or thousands) of dollars apiece. When an index moves 5% in one day (as it did frequently during late 2008), SPX options that were 40 points OTM in the morning were 10 points ITM by day's end. When that happens with an increase in implied volatility, losses (and gains) can be staggering.
There is good reason for the shorts to be afraid. One good risk management technique is to buy back those shorts – whenever you get a chance to do so at a low price. Remaining short, with the hope of collecting every last penny of premium, is a high risk game.
4) Reward vs. Risk
Expiration plays come with higher risk and higher reward. That's the nature of the game. In return for paying a relatively low price for an option, buyers have but a short time for the market to do its magic. Otherwise the option disappears into oblivion.
Most new traders believe they are locked into the trade once it has been made. Not true. You should consider selling those options any time that you no longer believe they can make money.
Don't sell them for a tiny premium, such as $0.05. For that price, take your chances. But when real cash is at stake, perhaps when the option is priced near $1, then it's a difficult choice: hold vs. sell. Make a reasoned decision.
Although it seems to be an obvious warning, when buying options near expiration day, please be aware of what must occur to earn a profit. Then consider the likelihood of that happening.
The same warning applies to option sellers. Time may be short, but when the unlikely occurs, the loss can wipe out years of profits. When there's just too little premium, cover the short position and leave the last bit of cash on the table.
5) Option Greeks – Delta and Gamma
The greeks are used to measure risk. Once measured, it is up to the trader to decide whether risk is acceptable or must be reduced. It's important to understand the greeks of your position and how they change when the underlying moves. It's not necessary to spend hours studying the data. Use the greeks to get a look at the big picture and decide whether your position is ok as is, should be adjusted, or closed.
As has already been mentioned, delta and gamma change more rapidly near expiration (if the option is anywhere near the money). Stay alert to these changes.
6) News Events
When news is released, the underlying stock often undergoes a substantial change in price. If you have a position, or are considering opening a new position, be certain that you know whether news is pending. Such news is most often a quarterly earnings report.
If you are a risk avoider, don't hold short options with negative gamma in the face of earnings releases.
Summary: Expiration is an exciting time for traders who are either long or short options. If you want to play in that arena, understand what you are doing. If you are a more conservative trader, it's easy to exit all trades before expiration draws too near.
The November 2010 issue of Expiring Monthly will be availale Monday, Nov 22. This month's issue focuses on commodity options.