Selling options before their expiration

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Holding an Option Through the Expiration Date

A stock option gives an investor or trader the right to purchase a stock at a certain stated price. This stated price is called the strike price. It does not matter where the actual market price of the shares currently sits.

The relationship between strike price and the current market price of a stock is a major determiner of the option value. If the stock price is above the option strike price, the option is “in-the-money” and exercising it will allow you to buy shares for less than you can on the regular stock exchange. However, if the stock is below the strike price, the option is “out-of-the-money.”

If the option is out-of-the-money, there’s no reason to exercise the option because you can buy the shares cheaper on the open market.

Approaching the Expiration Date

An option will have no value if the underlying security is below the strike price (in the case of a call option) at expiration. In this case, the option expires worthless and ceases to exist. When an option is in-the-money and expiration is approaching, you can make one of several different moves. For marketable options, the in-the-money value will be reflected in the option’s market price. You can either sell the option to lock in the value or exercise the option to buy the shares.

If your option is in-the-money at expiration, your broker will automatically exercise them, and you’ll have the shares in your brokerage account on Monday morning; for employee stock options, you must exercise in-the-money options before they expire.

The Rules

Holding an option through the expiration date without selling does not automatically guarantee you profits, but it might limit your loss. For example, if you buy a call option for stock A, which currently trades at $90, a decision has to be made as to whether to exercise the option at its expiration date, sell the option, or let the option expire. Let’s say the stock price goes up to $100 and the option cost is $2. If a decision is made to exercise the option, then the profit that would be made is $100 – $90 – $2 = $8.

Timing Is Everything

It is important to remember that some types of options permit the holder to exercise the option at specific times. An American-style option has no restriction. It can be exercised at any time between the purchase date and the expiration date. A European-style option, however, can only be exercised at expiration, and Bermuda options have specific periods when exercise is permitted.

If the decision is made to sell the option, then the profit made may be slightly higher. If the option is sold before expiration date, then implied volatility and the number of days remaining before expiration may increase the price of the option. Let’s assume that the price is higher by 10 cents. The profit made will be $10.10 – $2 = $8.10. The decision to sell the option assumes that it is in the money.

Short Positions Are Different

One scenario that calls for letting the option expire occurs when you are holding a short position on an option that is out of the money. If you are short a put option that is worth $2, closing the position will cost you $2 plus commission. However, letting the option expire will only cost you $2. In this case, no profit is made, but losses were limited.

Expiration Day Mistakes to Avoid with Options

Trading options on their expiration day can be an exercise in frustration.

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Trading options gives you the right to buy or sell the underlying security before the option expires. The closer an option gets to its expiration day, the faster it loses value. Weekly options expire every Friday and monthly options expire the third Friday of each month.

Option trading can be volatile and unpredictable on expiration day. You can protect your trading account by avoiding some of the more common mistakes option traders make.

One of the most common mistakes traders make with options is forgetting when these contracts expire. Depending upon the specific type of options contract you have purchased, rules regarding expiration will differ.

Close Your Trade Before Expiration

You opened your option position to make a profit and now your options are set to expire. If you have a profit, you may be tempted to keep the trade open on expiration day to get a little more money. If you have a loss, you may want to try to get some of your money back.

The reality is that the closer options get to expiration, the faster they lose their value. The odds of making a few more bucks are against you. To protect your trading capital, close out your option trades and take your profit or loss before your options expire.

Avoid Your Broker’s Margin Call

If you own one call option with a 50-strike price and the stock closes at $50.03, your option is automatically exercised; come Monday morning, you now own 100 shares of stock. You will get a margin call from your broker if you do not have enough money in your account to pay for the stock.

In that case, you must sell the stock to close out the trade. If the stock sells below the exercise price, the loss comes out of your trading account. You can avoid this mistake by closing out your open option positions before the market closes on expiration day.

Avoid Options to Buy Stock

Buying call options with the goal of owning the stock when the options expire is counterproductive. You buy call options to make money when the stock price rises. If your call options expire in the money, you end up paying a higher price to purchase the stock than what you would have paid if you had bought the stock outright.

You are also out the commission you paid to buy the option and the option’s premium cost. If you really must have the stock, buy it outright to avoid unnecessary costs and fees.

Know When European-Style Options Expire

Even seasoned traders can forget that European-style options expire on the third Thursday of the month instead of on the third Friday, as American options do. If your strategy calls for closing out your European option trade on expiration day and you forget about this time difference, your Europeans options will expire before you realize it. This could result in heavy financial losses for some traders.

You will not know if your option expired in or out of the money until late Friday morning or early afternoon when the settlement price is determined. Avoid this mistake by remembering to close out your European option trades on Thursday before they expire on Friday. When in doubt, create some sort of reminder or alert to help ensure that you don’t forget these expiration dates.

Should an Investor Hold or Exercise an Option?

When is it time to exercise an option contract? That’s a question that investors sometimes struggle with because it’s not always clear if it’s the optimal time to call (buy) the shares or put (sell) the stock when holding a long call option or a long put option. There are a number of factors to consider when making the decision, including how much time value is remaining in the option, is the contract due to expire soon, and do you really want to buy or sell the underlying shares.

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Right to Exercise Options

When newcomers enter the options universe for the first time, they usually start by learning the various types of contracts and strategies. For example, a call option is a contract that grants its owner the right, but not the obligation, to buy 100 shares of the underlying stock by paying the strike price per share, up to the expiration date. Conversely, a put option represents the right to sell the underlying shares.

Key Takeaways

  • Knowing the optimal time to exercise an option contract depends on a number of factors, including how much time is left until expiration and if the investor really wants to buy or sell the underlying shares.
  • In most cases, options can be closed (rather than exercised) through offsetting transactions prior to expiration.
  • It doesn’t make a lot of sense to exercise options that have time value because that time value will be lost in the process.
  • Holding the stock rather than option can increase risks and margin levels in the brokerage account.

The important thing to understand is that the option owner has the right to exercise. If you own an option, you are not obligated to exercise; it’s your choice. As it turns out, there are good reasons not to exercise your rights as an option owner. Instead, closing the option (selling it through an offsetting transaction) is often the best choice for an option owner who no longer wants to hold the position.

Obligations to Options

While the holder of a long option contract has rights, the seller or writer has obligations. Remember, there are always two sides to an options contract: the buyer and the seller. The obligation of a call seller is to deliver 100 shares at the strike price. The obligation of a put seller is to purchase 100 shares at the strike price.

When the seller of an option receives notice regarding exercise, they have been assigned on the contract. At that point, the option writer must honor the contract if called upon to fulfill the conditions. Once delivered the assignment notice, it is too late to close the position and they are required to fulfill the terms of the contract.

The exercise and assignment process is automated and the seller, who is selected at random from the available pool of investors holding the short options positions, is informed when the transaction takes place. Thus, stock disappears from the account of the call seller and is replaced with the proper amount of cash; or stock appears in the account of the put seller, and the cash to buy those shares is removed.

Four Reasons Not Exercise An Option

Let’s consider an example of a call option on XYZ Corporation with a strike price of 90, an expiration in October, and the stock trading for $99 per share. One call represents the right to buy 100 shares for $90 each and the contract is currently trading for $9.50 per contract ($950 for one contract because the multiplier for stock options is 100).

  • XYZ is currently trading at $99.00
  • You own one XYZ Oct 90 call option
  • Each call option gives the right to buy 100 shares at the strike price
  • The XYZ Oct 90 call option is priced at $9.50
  • October expiration is in two weeks

1.) Time Value

A number of factors determine the value of an option, including the time left until expiration and the relationship of the strike price to the share price. If, for example, one contract expires in two weeks and another contract, on the same stock and same strike price, expires in six months, the option with six months of life remaining will be worth more than the one with only two weeks. It has greater time value remaining.

If a stock is trading for $99 and the Oct 90 call trades $9.50, as in the example, the contract is $9 in the money, which means that shares can be called for $90 and sold at $99, to make a $9 profit per share. The option has $9 of intrinsic value and has an additional 50 cents of time value, if it is trading for $9.50. A contract that is out-of-the-money (say an Oct 100 call), consists only of time value.

It rarely makes sense to exercise an option that has time value remaining because that time value is lost. For example, it would be better to sell the Oct 90 call at $9.50 rather than exercise the contract (call the stock for $90 and then sell it at $99). The profit from selling 100 shares for a profit of $9 per share is $900 if the option is exercised, while selling a call at $9.50 equals $950 in options premium. In other words, the investor is leaving $50 on the table by exercising the option rather than selling it.

Furthermore, it rarely makes sense to exercise an out-of-the-money contract. For example, if the investor is long the Oct 100 call and the stock is $99, there is no reason to exercise the Oct 100 call and buy shares for $100 when the market price is $99.

2.) Increased Risks

When you own the call option, the most you can lose is the value of the option, or $950 on the XYZ Oct 90 call. If the stock rallies, you still own the right to pay $90 per share and the call will increase in value. It is not necessary to own the shares to profit from a price increase and you lose nothing by continuing to hold the call option. If you decide you want to own the shares (instead of the call option) and exercise, you effectively sell your option at zero and buy stock at $90 per share.

Let’s assume one week passes and the company makes an unexpected announcement. The market does not like the news and the stock sinks to $83. That’s unfortunate. If you own the call option, it has lost a lot, maybe almost worthless, and your account might drop by $950. However, if you exercised the option and owned stock prior to the fall, your account value has decreased by $1,600, or the difference between $9,900 and $8,300. This is less than ideal because you lost an additional $650.

3.) Transaction Costs

When you sell an option, you typically pay a commission. When you exercise an option, you usually pay a fee to exercise and a second commission to sell the shares. This combination is likely to cost more than simply selling the option and there is no need to give the broker more money when you gain nothing from the transaction. (However, the costs will vary and some brokers now offer commission-free trading—so it pays to do the math based on your broker’s fee structure).

4.) Higher Margin Exposure

When you convert a call option into stock by exercising, you now own the shares. You must use cash that will no longer be earning interest to fund the transaction, or borrow cash from your broker and pay interest on the margin loan. In both cases, you are losing money with no offsetting gain. Instead, just hold or sell the option and avoid additional expenses.

Options are subject to automatic exercise at expiration, which means that any contract that is in the money at expiration will be exercised, per rules of the Options Clearing Corporation.

Two Exceptions

1. Occasionally a stock pays a big dividend and exercising a call option to capture the dividend may be worthwhile.

2. If you own an option that is deep in the money, you may not be able to sell it at fair value. If bids are too low, however, it may be preferable to exercise the option to buy or sell the stock. Do the math.

The Bottom Line

There are solid reasons for not exercising an option before and into the expiration date. In fact, unless you want to own a position in the underlying stock, it is often wrong to exercise an option rather than selling it. If the contract is in the money heading into the expiration and you do not want it exercised, then be sure to close it through an offsetting sale or the contract will be automatically exercised per the rules of the options market.

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