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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. If you are not a member yet, you can join our forum discussions for answers to all your options questions. 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. Related articles: How Index Options Settlement Works Can Options Assignment Cause Margin Call? The Right To Exercise An Option? Why You Should Not Ignore Negative Gamma Want to see how we handle expiration risk? Start your free trial
What is the Truth? Is it true? Do 80% of all options REALLY expire worthless? Are 80% of all options buyers automatically losers which makes 80% of all options writers automatically winners in the options market without any risk? According to The Chicago Board Options Exchange (CBOE) here are the facts: Approximately 10% of options are exercised (The trader takes advantage of their right to buy or sell the stock). Around 55%-60% of option positions are closed prior to expiration. Approximately 30%-35% of options expire worthless. The CBOE goes on to point out that having an option expire worthless says nothing about the profitability of the strategy that it may have been part of: Multi-legged strategies can often require that one leg or more expire worthless although the strategy as a whole is profitable. Option positions closed prior to expiration may be profitable or unprofitable. Options that expire worthless may not be unprofitable if they were part of a strategy that involved other securities such as covered call writing. Only About 30% of Options Expire Worthless? What does it mean? ABSOLUTELY NOTHING! It doesn't mean that when you buy options, you automatically have 70% chance of winning, it also doesn't mean that if you write options, you only have 30% chance of winning. Here are some of the arguments used by different options gurus in order to separate you from your hard earned money: BE THE HOUSE – Not the Gambler! Be the insurance company and win 90% of the time! Get stable and consistent monthly income! Get 90% winning ratio with our strategy! Those arguments have no basis in reality. Insurance companies can lose significant amounts of money during periods of national disasters. Monthly income can become monthly loss during periods of high volatility. And so on.. If you are not a member yet, you can join our forum discussions for answers to all your options questions. Advantages of Options Selling Opportunity for monthly cash flow with high annualized returns. Opportunity to buy stocks at lower prices via naked puts strategy. Over the long term, Implied Volatility tends to be higher than Historical Volatility. Downside protection for put sellers or covered calls sellers. Options sellers tend to have a higher win rate (but a lower rate of return). Covered call writers may also capture dividends. Opportunities to trade in self-directed IRA accounts, especially covered call writing. Disadvantages of Options Selling Money can be lost is stock price dips below the breakeven. Profit potential is limited by the strike price. Assignment risk (may have to buy or sell shares). There is a learning curve and time commitment. In many cases, risk/reward is not favorable (you risk much more than you can gain). When using strategies like Iron Condors, one bad month can wipe out months of good gains. Why it doesn't matter Those who suggest that 80% of options expire worthless assume that if an option expires in the money, it automatically means a win for options buyers, which isn't true. If you buy a deep in the money option and the underlying stock moves against you, your options would still end up losing money even if it is still in the money by expiration! Ultimately, it is the direction of the underlying stock that determines if you end up profitable. How about hedging? If you bought options as part of overall portfolio using strategy like Protective Put, and your options expired worthless, is it necessarily a bad thing? Not if you stock doubled in value while you held those protective puts. And one final example: consider a strangle seller who sells options (both puts and calls) on high volatility stocks before earnings. He can gain $100 four times in a raw when the stock doesn't move in the money, but lose $1,000 during a cycle when the stock moved big time and one of the options became deep in the money. In this case, 9 out of 10 of the options expired worthless, but he still lost money. Even if the "80% expire worthless" myth was true, it doesn't matter - if you gain little when options expire worthless but lose big when they go in the money, your bottom line is still negative. But the most important thing is that most options are not held till expiration. Conclusion Percentage of options expiring worthless is completely useless to options traders. This is NOT what should impact your decision to become an options buyer or options seller. The only way to determine which options strategy suits you is by really learning about them, their reward risk ratios, practicing them and understanding which approach best conforms to your investment objectives, trading style and risk appetite. Options is risky no matter if you are an options buyer or seller, don't let anyone tell you otherwise. There is no such thing as becoming "banker" in the options market. Understand the risks of options trading and you will be profitable. Related Articles: Are Debit Spreads Better Than Credit Spreads? Selling Naked Put Options What Is The Best Options Strategy? The Road Not Taken Are You Ready For The Learning Curve? Can you double your account every six months? If you are ready to start your journey AND make a long term commitment to be a student of the markets: Start Your Free Trial
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 options 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 options 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 Options 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 options expiration draws too near. Related articles: How Index Options Settlement Works Can Options Assignment Cause Margin Call? Options Expiration: Six Things To Know The Right To Exercise An Option? Early Exercise: Call Options Want to learn more? Start Your Free Trial