As you well know, the third Friday of every month is known as “expiration Friday,” and I’d like to talk to you about how to manage your positions during this very active time for option traders.
Closing vs. Exercising
As an option buyer, whether calls or puts, you have right but not obligation when it comes to how you want to exit an option position. This means that, at any time during the life of your option contract, you can choose to either:
- Close your position and bank the profits or curtail your losses; or
- You can “exercise,” which means you tell your broker that you want to buy stock at the option strike (if it’s a call option) or sell shares at the strike (if it’s a put option).
Many people buy options with one of two intentions: They can become long (buy) a stock (if they bought a call) or “put” (sell) their existing long shares (if they bought a put) to someone else at the strike price of their respective options.
But remember, if you don’t want to wake up on the Monday morning after expiration with a stock position that you might or might not want (or that you may or may not be able to afford), you must instruct your broker beforehand that you do not want to exercise your option if it finishes in-the-money. Better yet, you can close the option (i.e., “sell to close”) directly. That way, as soon as your order is filled, the trade is completely shut down and you have nothing more to do with the option or the underlying stock.
However, what if that position was a profitable one and you simply ran out of time with your trade?
Rolling Your Option Position
When you are in a winning position, and it looks like the position is going to continue in your favor but time is running out due to expiration, you don’t have to say goodbye to your winning streak.
When you want to continue profiting from a position that’s moving in your favor, you have the ability to lock in your profits while exposing yourself to additional upside with a technique called “rolling.”
In fact, you don’t have to wait until expiration week to “roll.” If you’re sitting on a nice profit in an option that expires six months from now, there’s no reason why you should wait six months to close your position and risk losing out on all the gains you’ve made. When you roll, you bank your profits and use your original investment capital to buy another option in a further-out expiration month. If the stock keeps rising, you can “roll up” your calls to a higher strike price, or “roll down” to a lower strike if you’re using puts. You can keep the momentum going for as long as your stock is running (or falling).
In other words, you have an incredible opportunity to lock in your profits and limit your risk, while maintaining the same-size position. When my stock-trader friends tell me how much better stocks are than options, I remind them about rolling to protect profits in a winning position and get situated for more profits (which you can’t do with any other security other than options). And I win that argument every time!
Rolling works for long options, but what about when you are selling options against a long stock (or option) position to generate income?
Expiration and Option Writers
When you sell options against your long stocks (or other long options) to collect premium while stocks are standing still or simply moving slowly, you do so to take advantage of time decay (i.e., the erosion of extrinsic value that happens most rapidly as expiration draws near). You will collect premium when you initiate the position (i.e., you “sell to open” the option). And, if the position works in your favor, the value of the option will decline.
I’m always surprised to hear option sellers debating whether to close the position before expiration (i.e., to “buy to close” the option) or to simply let it “expire worthless” if the position goes as expected and the option value declines.
First of all, if you are in a covered call position, it is a repetitive strategy that you do month after month. So, it shouldn’t be a problem to close out the expiring position before initiating the new one. However, if you aren’t planning to continue the position (I might ask, why not?), the risk of it NOT expiring worthless is why you close the position. Instead of watching and waiting for the option to expire, it’s best to buy it back. Chances are, you’ve gotten the lion’s share of the value out of the option, so it’s actually good to buy it back for a small loss.
Volatility tends to pick up during expiration week, as traders and investors take their old positions “off the board” and get repositioned in new expiration months and/or strikes. This could actually turn the price of your option in the wrong direction! If the stock is trading close to your option strike, you are taking a big risk in leaving your position to the fate of the expiration gods. The front-month, at-the-money strike options’ prices can change very quickly.
In other words, the option might be worth 10 cents now, but could shoot up to $1 going into expiration. That is risk you could have — and should have — removed from the table. This makes the case for not waiting until 3:59 p.m. Eastern on Friday to call your broker to close out!
Exercise vs. Assignment
Earlier, we talked about “exercise,” which is the buyer’s right — but the buyer is not obligated to exercise. So, who is obligated in the buyer/seller relationship?
It is the individual who sold the option who is obligated to fulfill the obligation that they got paid to take on.
With American-style options (most equities), option buyers have the right to exercise their option at any time during the life of the contract; sellers get assigned when a buyer exercises. As we saw in our covered-call example, the option seller was selling calls against a long stock position. You don’t ever want to be short options unless you have some type of hedge in case the position goes against you. The covered call strategy is best used on a stock that is in a slow-grinding uptrend. As the call writer, you can also profit if the stock stays still or even if it moves down a little bit.
However, if the call moves in-the-money at expiration (i.e., instead of declining in value, it starts gaining intrinsic value, or the amount by which it is in-the-money), you run the risk of having someone who bought that same option want to exercise it, which means that you as the seller would have to sell shares to them at the strike price.
The good news? You own the shares and can fulfill the obligation. The bad news? You’re out of your position!
Now, don’t blame your broker for taking you out of your position. It’s actually the Options Clearing Corp. (which guarantees both sides of a trade) that takes the people who are short that option and does a “random lottery” to determine who will fulfill the buyer’s obligation. To avoid assignment, you can buy back your short option at any time. If you needed another reason to close out your expiring options, remember that if your short option is in-the-money and you haven’t yet been assigned, you will be at expiration.
Expiration Does Not Mean Opportunity Runs Out
Options expiration sounds a lot scarier than it really is. Try to think of it in a more positive and realistic light: Expiration should serve as your reminder to “clean house” on your options account. You don’t have to watch the markets from moment-to-moment for as long as they’re open, but it pays to check in more frequently than you would with your longer-term holdings.
As an options investor, you’re spending less money to control the same-sized position in a stock to capture gains much more quickly than the traditional stock investor might ever be able to see. You don’t want to miss out on the opportunity to bank profits while you have them, to adjust losing positions while there’s still something left to work with, and to get repositioned for even better returns in the weeks and months to come.
When you think “expiration,” think “opportunities” to make more money.