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 6 options expiration tips. 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 traps when trading options on expiration day.
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.
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 call.
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 (except for weeklies).
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 on expiration day.