The combination of after-hours trading and options expirations can be a toxic mix. As such, advisors certainly need to be aware of the pitfalls that clients can be exposed to under the right — or wrong — circumstances.

On that note, a story I have told in the past is worth repeating. A long-time reader sent me an email back in 2006 about his experience with Google Inc. puts at the October 2006 expiration.

The reader had purchased 10 Google October 460 puts in September 2006. His goal was to profit on a downturn in the value of Google shares, with the limited-risk advantage of an options contract. The most he could lose was the cost of the option — or so he thought.

On the last day of trading, Fri., Oct. 19, 2006, he tried to sell (i.e., close) his Google puts at the limit price. He was never able to sell at the limit price. As the stock was trading so close to the strike price and because he believed he controlled the decision to exercise or not, he decided simply to let the option expire.

The limited-risk concept is one of the advantages of trading options on volatile stocks such as Google. The problem is that the limited-risk theory only works if the trader is willing to exit the position prior to expiration.

At expiration, the U.S. Options Clearing Corp. , which is the buyer and seller of last resort for all options contracts, has provisions for the “automatic exercise” of certain in-the-money options. What this means is that the OCC will automatically exercise an expiring equity call or put in a customer account that is 5¢ or more in-the-money and an index option that is 1¢ or more in-the-money. (The former figure used to be 25¢ in the money but was reduced to 5¢ prior to the October 2006 expiration.)

At this point, it’s important to understand that options expire on the Saturday following the third Friday of the expiration month. Even if the option ceases to trade when the market closes on the third Friday at 4 p.m., the contract itself exists as a legal entity until the next day.

It is on the Saturday when options are exercised and assignment notices get delivered to various brokerage firms. It is at this point that the OCC implements a procedure referred to as “exercise by exception” that allows for the automatic exercising of an option in a client account.

In this example, the Friday 4 p.m. closing price for Google was US$459.67. The long puts in the reader’s account were in-the-money by US33¢ and so were automatically exercised by the OCC on his behalf.

The exercise notice effectively meant that the client sold 1,000 shares of Google at US$460 a share. As the client did not own the shares, he discovered on Monday morning that he was short 1,000 shares of Google and did not have sufficient margin to cover the short sale.

At this point, we have a miscalculation by the advisor and the client, but one that can be rectified by simply purchasing Google shares on the following Monday morning to settle the short sale. The problem is that over that particular weekend, Google released its quarterly earnings, which beat Street estimates. In addition, the company announced the purchase of YouTube LLC. These were significant events that positively affected the price of Google’s stock.

I have used Google as a case study for a reason. It happens to be a high-profile company with a volatile earnings pattern. More important, management has decided to release its quarterly earnings on the dates of its options expirations in January, April, July and October. This is something to be aware of when trading Google options.

But I digress. In this case study, traders digested the YouTube takeover and the better than expected earnings and, by Monday morning, the stock was surging higher. The client was forced to close out his unintended short position at US$478 a share. As such, the total loss on the 10 Google October 460 puts was a substantial $18,000, which is in addition to any losses that occurred on the original purchase price of the Google puts.

Obviously, no advisor wants to expose a client to that type of risk — especially when it is preventable. The client could have simply closed the long put position at the current market price rather than on a limit order; or, failing that, could have requested that the option not be exercised. That request would have been sent to the broker’s back office and then the option would not be subjected to the automatic exercising.

@page_break@There are other examples of options that have expired out-of-the-money but ended up in-the-money with after-hours trading. In the Google example, the stock traded higher after the close of domestic markets, settling in the US$468 range. Traders who were long the October 460 calls that were out-of-the-money at 4 p.m. on Friday were now in-the-money based on the after-hours trading.

So, would the call buyer have had his or her options exercised automatically?

Generally, the answer is “no” because automatic exercising is driven by the value of the underlying stock at the 4 p.m. trading close. However, traders can request that options be exercised even if the stock closed at a price that was out-of-the-money.

Each investment dealer has what is known as “cut-off times” to send exercise instructions to the OCC. Advisors who advise clients on options should be clear on the exercising procedure and their firm’s relevant cut-off times. IE