by Adam Warner | February 11, 2010 10:00 am
A reader recently asked about how after market trading affects options on expiration Friday since options technically expire at 11:59 a.m. on the following Saturday.
The reader wrote: “Some strategies call for allowing ITM options to be exercised and, for others, expecting their ITM options to expire worthless, thus allowing them to keep the premium, find out on Monday that after hours trading drove the options OTM. I am constantly reading up on options, and I find it misleading when people say options expire on Friday, ignoring what can happen to your position after hours.
“I found out the hard way when I was new to options and puts I had bought on SNDK expired OTM — or so I thought — only to wake up Monday morning to a margin call from my broker. I made money in the end because the stock was tanking, but had the stock reversed the following Monday I would have been in trouble! I also noticed that many times for certain stocks that get pinned, the pinning action continues after market.”
There are many moving parts here, so let’s dig in.
Options do expire at 4 p.m. on the third Friday of the month in the sense that they no longer trade. But the stocks themselves keep trading after hours, so, as this reader notes, what’s in-the-money (ITM) at 4 p.m. on Friday can be out-of-the-money (OTM) by 5 p.m., or vice versa.
ITM options will automatically exercise based on the 4 p.m. closing price. The definition of ITM has changed over the years, and will also vary depending on your status and the policies of your clearing firm.
A “professional,” like a market maker, for example, may now automatically exercise options if they are as little as a penny ITM. A “customer” may only auto-exercise if the options are a nickel or dime ITM.
But automatic does not mean obligatory. You can always contact your clearing firm with an “exception.” An exception may take the form of exercising an option that closed OTM at 4 p.m.
Say, for example, XYZ closed at $49.90, and you own expiring calls with a strike price of $50. You may still exercise them, i.e., buy stock at $50.
Why would you do that?
Well suppose that it’s 4:30 p.m., and XYZ is trading at $50.50. You should exercise your calls, and then sell your $50 stock out for a 50-cent profit.
You do not, however, have unlimited time to exercise those options. The reader is correct to state that options technically don’t expire until noon on Saturday. That’s because options don’t “settle” until then as expiration-related D.K.s (i.e., Don’t Knows, or trades where the two sides don’t agree on what they traded) resolve. But, by rule, you must contact your clearing firm with an exception by 5:30 p.m. on Friday.
Does this window get abused? That is, do people somehow exercise options after 5:30 p.m. on expiration Friday and before they settle on Saturday?
Yes. I heard a horror story in ViroPharma Inc. (VPHM) a few years back, where bullish news came out on Sunday, yet someone was prescient enough to exercise OTM calls that opened ITM by Monday.
The moral of the story is, if you have at-the-money (ATM) options still open at 4 p.m. on expiration Friday, follow the after-hours trading.
When in doubt, contact your clearing firm and make your intentions clear so as to avoid margin problems.
If you’re short ATM or near-money options and don’t cover, you’re at the mercy of the system. Ninety-nine times out of 100, nothing will happen, but always keep in mind that the risk extends past the regular 4 p.m. close.
Tell us what you think here.
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