Making Sense of Expiration

Expiration can be one of the most confusing topics about options, a trading product with no end of complications. This is expiration week for most January, 2011-dated options with trading ending on Friday and actual expiration occurring on Saturday.

Option traders of all experience levels have questions about expiration, from ways to make some quick bucks (they think), to timing a Condor trade to take best advantage of time decay to expiration. Option expert Mark Wolfinger regularly answers these types of questions on his blog “Options for Rookies” where these questions first appeared.

Why not exercise?

Q – You’ve said you don’t like to exercise the options you own. Why not?

A – My problem with exercising, as a general practice, is that someone who bought an option for a specific reason forgets the original reason and suddenly owns stock. Along with that stock comes a great deal more risk than the original trade. That’s just a bad idea, and cannot work over the long term.

When you buy an option (or spread), if your original premise doesn’t become reality, accept that fact and exit the trade.

Why doesn’t everyone do this?

Q – Why not sell 10,000 options on expiration day that are ‘way out of the money’ for $0.01 each. Isn’t that a risk free way to make $10,000?

A – Selling very cheap options is a losing strategy. Sure these options expire worthless almost all the time. Just think about the one time when this turns out not to be true.  Stocks can, and do, make major moves in the final few minutes of trading on expiration Friday. Attempting to make such a tiny amount of money is financial suicide.  Think about the loss if just one of these trades results in an option moving into the money. With 10,000 contracts, that costs $1,000,000 per point. Not only that, but can you imagine how your order to buy 10,000 (now in-the-money) calls is going to affect the price of those options when the stock price is surging?

Do all OTM options expire worthless?

Q – When an option is out-of-the-money at expiration, does it always expire worthless?

A – It’s a basic question, but important. There are two replies.

The first is, yes, when an option is out-of-the-money (OTM) at expiration it always expires worthless. However, ‘always’ is more like 99.99%. That’s because the owner of an option has the right to exercise. That right is not revoked just because the option is OTM. Thus, when an option is OTM by one or two pennies, it is possible – unlikely – but possible that the option owner would want to exercise. Maybe a trader is short stock and needs it to cover. Or there’s big news about the stock after the close on expiration Friday.

Time decay, Condors and expiration …

Q – Regarding time decay for OTM and at-the-money positions (ATM). It’s a given that time decay, or theta decay, accelerates in the last 30 days of trading. So if I want to trade an iron condor with an OTM position, why not open the position at 60 days to expiration and close it about 30 days before expiration?

A – Time decay is what makes trading iron condors profitable. It may be good to own the position when time decay is most rapid, but that is not typical of 60- to 30-day iron condors. That works only when the calls and puts are both quite far OTM. That means a tiny premium to start the trade. In the real world, most options are not that far OTM and have enough time premium to belong in the standard decay group.

Condors and expiration continued …

Q – On the non-front month condors, what range days from expiration do you look to enter them? Are you in the 60-90 range, or do you look further out?

A – I’m not a fan of trading front-month positions with condors. The time decay is nice, but the negative gamma is just too large for my comfort zone. This is not something to debate. Higher risk and higher reward go together and I prefer less of each. I recognize that the majority of iron condor traders prefer the ‘action’ involved with trading front-month options.

In general, I enter new iron condor positions as soon as I exit my previous positions.  When open positions move from second month to front-month due to the passage of an expiration date, is when I prefer to close the trades.

Follow Mark Wolfinger on Twitter @MarkWolfinger.