Automatic Exercise, After-Hours Risk, and Other Options Expiration Issues

Obviously, with a name like OptionsHouse, the majority of our customers trade options. Each expiration Friday, our trade desk is flooded with calls as we inevitably have customers that have questions around the actual expiration process. 

“What happens if I am long options, and they finish in-the-money?” … “Will I be assigned?” … and et cetera.  Hopefully, I can walk through some common expiration-afternoon questions here and shed some light on the process.

Automatic Exercise

First, the Options Clearing Corporation (OCC) automatically exercises options whose official close is one penny or more in-the-money.  Those holding long calls would buy 100 shares for each call they owned after the close on Friday afternoon.  Those with short calls might sell 100 shares for each call they were short as of the close.  The short does not control the exercise.

For those long the options, it is your right whether or not you exercise these calls.  If you wanted to, you could call our trade desk and ask to not exercise an option that finished slightly in-the-money.  That way your option would expire worthless but you would not have to take delivery of the stock (more on this later).  Please note that your options that settle in-the-money on the close will be automatically exercised on expiration if you don’t proactively ask that they not be exercised.

After-Hours Activity

Question #1: what happens if the stock price moves after 4 p.m. Eastern Time on Friday?  Well, this is where it starts to get interesting.  As any of you who trade in the after-hours market know, stocks continue to trade after the bell.  Option strikes can move from out-of-the-money to in-the-money, or vice versa. 

Trust me, the professionals in this market watch this very closely. They have approximately 1.5 hours after the close to make their decision on whether or not to exercise.  The most common examples of this behavior are with ETFs like the Spiders (NYSE:SPY) and the PowerShares QQQ Trust (NASDAQ:QQQQ).  These options even trade through 4:15 p.m. Eastern, but the options are settled based on the 4 p.m. close.  Because of this, you might be assigned on an option you are short when you don’t expect it. 

Small moves in broad-based ETFs are risky, but probably controlled.  However, when there is an unexpected event right after the close on an expiration Friday, things can get really crazy.  Over the years I have been trading, there have been a handful of instances where a major event (think FDA ruling) occurs that moves a stock a huge percentage.  The stock might close at $51, but if a drug is approved, the stock could be trading at $73 after the close. 

In this instance, one could expect to get short calls assigned even at the $55, $60, $65, and $70 strikes.  All of them might not be assigned, because if the person long the calls did not realize what happened, he may not call in to exercise them.  Again, this is very rare, but it has happened.  For those who tend to be sellers of options, please remember: YOU DO NOT CONTROL WHETHER OR NOT YOU GET ASSIGNED … EVER.   If something happens, you are at the whim of the people long the options.

How can you avoid some of these corner cases?  Well, you could close your positions before 4 p.m. Eastern.  If you do this, there is no exercise or assignment risk.  However, if you are short, you might be paying commissions and a small fee to buy back the options you feel will be worthless in almost every situation. 

I think you should assess these case by case.  Is there risk in being short calls in the SPY that are 10% out-of-the-money?  Yes, but the odds of the market going up 10% in the 1.5 hours after the close are very remote.  It is probably a risk you can live with. 

The odds are much different if you are short options in, for example, Priceline (NASDAQ:PCLN) that are only 10 cents out-of-the-money near the close.  Since PCLN is both volatile and a high-dollar priced stock, the chance this stock could move through your strike is actually very high.  By not closing out of these options, you might have to take delivery of a lot of stock, which may not be ideal for your account size.  At that point, closing the options out shortly before the close takes a lot of risk off the table.

Question #2:  what happens if I exercise or get assigned options and take delivery of the stock?  A lot of this depends on the size of your options trade vs. your account value.  The biggest risk is you end up with much more risk than your account value can justify.  You will have to close the stock position on Monday morning or bring in a lot of money. 

Think about this scenario:  you have $5,000 in your account.  If you sold five of the 170/175 bear call spreads in Netflix Inc. (NASDAQ:NFLX) for $3, you would have to post $2*5*100, which equals $1,000 (and leave the $1,500 you collected in premium in your account).  So this trade takes up 20% of your account.  This is probably a little too high, but within the realm of reality. 

Your maximum risk of the options position alone is only $1,000. If you leave the trade on until expiration and the stock closes at $171, however, theoretically you should be happy.  The spread was worth $1 at expiration and you originally collected a net credit of $3, so your profit is $2.  However, if you did not close the spread, your trade is far from over.  You will be assigned on the $170 calls and the $175 calls will not be an exercise. 

On Monday, your account will be short 500 shares of NFLX.  That is $85,500 worth of short stock!!! Margin on this trade is $51,300.  Your account probably has $6,000 in it.  On Monday morning, you have a couple of choices: first, if you have $45,300 laying around, you can wire it into your account and keep the short position. 

Second, you can buy back the NFLX stock. If the stock is still trading at $171, then no harm no foul.  You still made $1 on the put spread.  If the stock is trading lower, you actually would make some money.  If the stock starts to trade higher, your whole account value is at risk pretty quickly.

NFLX is a pretty volatile stock.  If the stock is up 8.5% on the open on Monday, your account would be wiped out.  That is not a very big move for this stock.  There is almost no way that at the time of this trade, a customer with $5,000 in his account was thinking “I am willing to lose my entire account value, and then owe OptionsHouse money if the stock moves 8.5% over the weekend.”

Getting into a situation like this puts the OptionsHouse trade desk and risk departments in a bad spot.  Some customers want to wait until Monday to sort this out.  Others did not know about the risk, and they would have rather we busted out of the trade for them.  We cannot read your minds, so we close out of positions that we deem too risky for the account size before the market closes on Friday afternoon. 

This depends on the underlying dollar amount of the stock in which you have expiring options positions, as well as the dollar value of your account.  This does not mean we will close positions down due to the size of your account value.  You can expect that if you leave one of these positions open through expiration, you will have some decisions to make Monday morning (along with likely a margin call). (Sign up for our free webinar series on margin calls for more information on these fun things). 

Hope this article is helpful; please make sure you pay attention as your positions head into expiration.  All traders lose money on some of their trades over time.  The bad ones lose money but don’t understand why.  You should know the risks of your positions.

Please refer to Characteristics and Risks of Standardized Options, copies of which can also be obtained by contacting our Customer Service Department at customerservice@optionshouse.com. 

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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