The Life Of An Options Contract

Once I dove in and understood the deeper mechanics, I found I made fewer mistakes and my trading was generally sharper and more precise.

As with everything, reviewing the ‘basics’ increases your mastery and skill - and like most 'basics,' there can be incredible depth the deeper you dig. Keeping the ax sharp helps you become a better options trader and able to take advantage of those opportunities to profit when presented.

If you were lucky enough to learn about the basic mechanics of equity markets in school you learned that a company issues shares, which caps the supply.

But what about options? Where do they “come from” and where do they “go”?  In this article, we’ll refresh our understanding on the topic and I bet you’ll also learn something new.

The Basics

Our basic review starts with a discussion on where options are traded: The Chicago Board Options Exchange (CBOE), over-the-counter, and on several other exchanges (such as the Philadelphia Stock Exchange).
 

The CBOE, currently handles a daily trading volume of around 4.5 million contracts, making it the world's most active exchange for equity-based options.

The marketplace of buyers and sellers drive activity.  You know that it's the buyer of the option who holds the right to exercise the option and can do so by informing the writer that she wishes to buy (for a call option) or sell (for a put option) the specified shares at the specified price (strike price or exercise price–more on strike prices below). 

If the purchaser does not exercise the option during the specified period, the option expires, the writer keeps the premium, and the purchaser has no further rights.  Most options are not exercised since traders can offset their positions and realize their gains in the options market without going to the trouble of selling or purchasing the actual stock.

How Strike Prices and Expirations Work

The strike price of an option is the price the underlying stock will be exercised at (bought or sold) unless the option expires.  When options are issued, the strike price is set in close proximity to the stock’s current market price. If Facebook (FB) were trading at $150, you will find contracts issued at intervals of five points or $5 relative to the price of the underlying stock. So, in this example, a chain of options expiring on April 21, 2018 (see below calendar), may include calls and puts with a strike price of 145, 150, 155 and so on. Stocks trading at $25 or less have intervals of $2.50 and stocks trading over $200 have intervals of $10.

Some stocks whose market price is greater than $1 and less than $50 may be selected by the CBOE to trade listed options at intervals of $1. Those options are part of what is called the dollar strike program. 

You’re likely familiar with the month that options expire, but do you remember the exact time options expire?  All options expire at 11:59 p.m. Eastern Time on Saturday following the third Friday of the expiration month. Note, this is not the same thing as the third Saturday since the month might start on a Saturday. Before options expire, trading in options must cease (4:00 p.m. Eastern Time) on the business day before expiration. This would occur on the third Friday of the month unless Friday was a holiday.

There is also a cut-off point beyond which options may not be exercised (5:30 p.m. Eastern Time) on the business day before expiration. This would occur on the third Friday of the month unless Friday was a holiday.

For 2018, here is the calendar of expirations from January to December:

You may also choose alternative options that expire on a weekly, monthly, or quarterly cycle.  These are reserved for underlying stocks with the most sustained options activity.  The rules for closing trades and expiration are the same, regardless of the cycle you choose.

Standardized Contracts Must Be Written First Before They Are Held

Writing involves selling a contract (entering the obligation) before owning the contract.  This is also referred to as a short position.  Conversely, a long position or holding (owning the obligation) is created when buying the contract without a subsequent short position. In short, long contracts are the opposite of short contracts. Fairly intuitive.

Opportunities for buying an option cannot exist unless an obligation to sell or purchase that same stock is created by the writer. This can only be created when the same contract is written by some contra-party.  This brings us to a very important concept – open interest.

What is Open Interest?

An important measure of options activity and liquidity is open interest. Open interest is a term that simply means the unexpired contracts that are listed on an exchange that has not been exercised against or closed prior to their expiration. This differs from volume, as volume is a reference to the number of contracts trading hands over a given time period (e.g. daily, weekly, monthly, etc.). These trades can be both opening and closing transaction. 

What does open interest tell us? The higher the open interest for an option, the more buyers and sellers there are in the marketplace.  This usually equates to a tighter spread between the price you pay for the option (ask) and the price you sell an option at (bid), which saves you money and allows you to quickly take action in both opening and closing positions. A low open interest indicates a lower interest in the contract, making it less liquid with a wider bid-ask spread.  A wide bid-ask spread can cost you lots of money and headaches.

How Open Interest is Decreased through Closing Positions

Closing open options positions prior to expiration reduces the open interest. Closing positions can happen in one of two ways: a closing buy and a closing sale. If the original options position taken was a “sell to open” (you wrote or shorted the option), you can close the position with a closing buy, which would be the contra-trade or opposite position. This transaction is allowed at any time during the life of the options contract, up to and including the date of expiration.

When your initial transaction is “buy to open,” where you were long the option as the holder, the contra-trade that you can make up to and including the expiration date is a closing sale. It is important to remember that this takes place before exercise because if you are exercised against, you no longer control your fate. This is more critical for sellers or short positions than it is for holders since, as was discussed previously, a writer has an obligation to perform some duty relative to the contract (buy or deliver the underlying stock) while the holder has the right but not the obligation to do anything.  However, it’s important to note that most brokers will take this action on your behalf for contracts left open at expiration; we will discuss this in more detail below.

Role of the OCC

The Options Clearing Corporation or OCC is the clearinghouse organization for all options transactions that trade on an exchange (called listed options). The OCC is the largest equity options clearing organization in the world and is dedicated to financial integrity and bringing stability to the options markets. We discussed the importance of the OCC in this past article on SteadyOptions. 

The OCC, in addition to providing the risk disclosure document required at account opening, maintains the efficiency of the market by exercising open positions prior to expiration (also see below).

Open Options Contracts at Expiration

Contracts that are still open (those that have not been closed or exercised) at expiration face one of two fates: expiration or exercise. The execution fate is one more reason why the options market is one of the most efficient financial markets in the world. The OCC, in one of its specific duties, will randomly assign an exercise notice for all open positions, matching opening sales and opening purchases with each other when they are $0.01 in-the-money (ITM).   Important to note that due to the random assignment and the ITM rule, it is possible that some of the legs of your spread will be exercised while the other legs expire without further action.

Options at expiration that are at-the money (the strike price is the same as the market price of the underlying stock) or out-of-the-money (strike price is below the market price of the stock) will not be automatically exercised by the OCC or the broker.  If the holder takes no action, the option will expire worthless. This is good news for the seller who did not close their position prior to expiration because it allows them to keep the premium received for selling the option.

Conclusion

Consider this information the basic working knowledge every options trader needs to understand before trading commences. 

This information is readily provided when you open an options account and is contained in a document that is titled, Characteristics and Risks of Standardized Options, first published by the OCC in 1994. It's a bit of a long read, but all traders should review it.  The document is called the risk disclosure document that must be given to every new account holder when opening an options trading account (before the first trade takes place) and must be provided periodically (typically on an annual basis by way of mail or electronic delivery) to existing options account holders.

If you’re like me, it’s too easy to get wrapped up in your trades. It’s good to take a step back from time to time and remind ourselves of the mechanics so that we don’t find ourselves in a sticky situation.   Hopefully, this information serves as a good refresher for you.

So trade with confidence knowing that you fully understand all the eventualities of your trades.

Drew Hilleshiem is the Co-Founder and CEO of OptionAutomator, an options trading technology startup offering a free options screener that leverages Multi-Criteria Decision Making (MCDM) algorithms to force-rank relevancy of daily options opportunities against user’s individual trading criteria. He is passionate to help close the gap between Wall Street and Main Street with both technology and blogging.  You can follow Drew via @OptionAutomator on Twitter.