Don’t Fall Victim to These Mistakes
Options expiration. When you sell options, it’s an anticipated event. When you own options, it’s something to dread. At least that’s how most people view expiration day.
If you trade options, there are things you must know, and steps you should take, to avoid any unpleasant surprises on the third Friday of each month. (True expiration is the following morning, but for our purposes here, that is just a technicality.)
I’m going to provide you with some pointers for handling options expiration day.
Keep reading to make sure you don’t get caught in any of these expiration traps.
#1 Avoid a Margin Call Following Expiration
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 five July 40 calls, makes no effort to sell them, and decides to allow the options to expire worthless, that’s fine. 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 third Friday.
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 shares — even with 50% margin — and are forced to sell them. So please don’t forget to sell your long options.
#2 Don’t Exercise
If you own any options, don’t even consider exercising. You may not have the margin call problem just described, 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.
If you really want to own stock when buying options, you must plan in advance, or you will be throwing money in the trash. For most individual investors, especially inexperienced ones, 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. There are exceptions, but in general, DO NOT exercise options. Sell those options when you no longer want to own them. It does not matter if you have earned a profit or taken a loss, when you no longer want to own the options, sell them.
#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.
When you sell an option, you must understand the option owner has the right to exercise that option at any time prior to expiration. When that happens, it should be neither a total surprise nor a problem. When you write a covered call, being assigned guarantees the maximum profit for the trade. Surely that’s good, and not bad.
If you sell options with no position in the stock, be certain you can meet any margin calls if you are assigned an exercise notice. Your broker can supply the answer if you cannot figure it out for yourself.
But don’t be afraid of this scenario. Being assigned prior to expiration is usually beneficial from a risk-reduction perspective.
#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: options on the S&P 500, Nasdaq and the Russell 2000, but not on the S&P 100 Index. (Note: These are index options and not ETF options. Thus, the SPDR S&P 500 (NYSE: SPY), PowerShares QQQ Trust (NASDAQ: QQQQ) and iShares Russell 2000 Index (NYSE: IWM) are all American-style options.)
Here are the three main differences:
1. European options cease trading when the market closes Thursday, one day prior to “regular” options expiration day.
2. The settlement price is NOT a real world price. The final “settlement” price — the price that determines which options are in the money, and by how much — is calculated by using trade data from early in the trading day on Friday. However, the number is not made available until much later.Thus, when you observe an index price early Friday morning, do not believe that the settlement price will be anywhere near that price. So be careful. Often this settlement 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.
3. 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. It’s equivalent to buying or selling the option at its intrinsic value. Once again, that value is unrelated to Thursday night’s closing price.
Learn more about European options.
#5 Don’t Hold a Position to the Bitter End
It’s not easy to let go when you bought options. You paid a decent premium for those options and now they may have declined 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?
If there is no good reason to hold, cut your losses and sell out those options before they fade to zero.
Is the shoe on the other foot? Did you sell that option, or spreads, 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. It’s not a good plan to hold those options until expiration, especially when it’s weeks away.
#6 Negative Gamma is Not Your Friend
When you are short options, you are short gamma, and most of the time that’s not a problem. You were paid a nice price for the options and are watching those options evaporate at a decent rate.
But this is not free money. There is risk that the stock may make a move large enough so that it threatens to move into the money.
When you are short options, they come with negative gamma, and it’s the big, bad enemy. When the reward is small, respect this guy and get outta town. Cover those gamma shorts, take you good-sized profit, and don’t bother with the crumbs. Let the gamblers have those.