It used to be that you could count on some basic principles for trading options. For instance, out-of-the-money options were always worthless upon expiry and options that had time value were never exercised. But with fast markets, liquidity constraints in some options series and after-hours trading, many of these old rules no longer apply.

After-hours trading has created a particularly difficult environment for options traders. Although many are surprised to see out-of-the-money options assigned, others question why their specific options contracts were not exercised at a time that would have been to their advantage.

Case in point: take Jan. 20, the last day of trading for the January options, even though they didn’t expire that day. Rather, options expire on the Saturday following the third Friday of the expiration month, which was Jan. 21 in this instance. The Saturday expiration allows traders the opportunity to exercise their in-the-money positions.

Suppose you were holding five XYZ January 50 calls. At the end of regular trading on Friday, Jan. 20, XYZ closed at $50.50. The January 50 calls were “in the money” and went off the boards at 50¢. If you were long the January 50 calls, the options would have been automatically exercised on Saturday.

So, on the morning of Monday, Jan. 23, you check your account and notice you are holding 500 shares of XYZ, trading at $48 per share and dropping fast. That happened because XYZ decided to release quarterly earnings numbers after the close of trading on Friday, Jan. 20. With lower than expected revenue, traders began selling the stock after hours. When the after-hours market closed Friday evening, XYZ was already trading at $48 per share.

That’s a major change in your position in just a few hours of trading. Although you may have been happy that the exchange automatically exercises in-the-money calls based on the closing price at the end of regular trading hours, you certainly didn’t want to have those options exercised on your behalf, having witnessed the carnage in after-hours trading.

The rule is: in-the-money options are exercised based on the closing price during regular trading hours. This means the decision to exercise is not based on the movement in the after-hours market.

The same thing can be said for put options. Suppose you were short five XYZ January 50 puts. At the end of trading on Friday, Jan. 20, your puts were out of the money, as well as worthless upon expiry. If you were short those puts, you would not want to see shares of XYZ in your account on Monday morning.

However, this could happen because it’s possible for traders to request that an out-of-the-money option be exercised. This is not something that I would have ever thought possible until the advent of after-hours trading. And, to be fair, even in the current market environment, the idea of assigning an out-of-the-money option is remote. But over time, as activity in the after-hours market picks up, you are going to see more of this kind of behaviour — and it is going to have an impact on options traders.

We are already seeing an impact on the level of options premiums, though. As you know, the time value of an option erodes in an exponential fashion. That’s simply a long-winded explanation that says options lose most of their value in the final three months before they expire. More recently, however, I’ve noticed that options are retaining more of their value much later in the expiration cycle. A lot of that has to do with after-hours trading, especially when you see volatility expand in after-hours trading because of an important announcement that was released after the close of regular trading.

As an options trader, you have to change the way you view expirations as a result. In the past, you might have let out-of-the-money options expire; but now, it makes sense to close out a position before expiry. Even though there is a small cost associated with that, at least you know where you are at a given point in time.

There may also be times when you will want to exercise your option early because of liquidity constraints. Historically, it never made much sense to exercise an option that had time value remaining, but that, too, has changed.

@page_break@For example, assume XYZ is trading at $52 per share. The fair value for a one-month XYZ 50 call might be $2.25. Assuming the option is trading at $2.25 per share, its price is made up of $2 intrinsic value (the difference between the current price of the underlying stock and the option’s strike price) and 25¢ per share of time value (time value being the difference between the option’s price and the option’s intrinsic value).

Given those prices, it makes sense to sell the option at $2.25 rather than exercise the option, take possession of the stock at $50 and sell the stock at $52 per share immediately thereafter. But, if you exercise the option, you give up the 25¢ per share in time value.

This theory and its math make sense, but theory doesn’t always apply in the real world. For instance, what happens when the bid/ask spread on the option distorts the pricing model? In some cases, the bid/ask spread in an illiquid market makes selling the option for more than its intrinsic value all but impossible.

Consider the XYZ 50 call that was used in the previous example. Even though the fair value was $2.25, the actual market for the call might be $1.90 bid and $2.30 asked. If that is the current bid/ask spread, you would be selling the option on the bid price and buying on the asked price. In this case, it may make more sense to exercise the option, take possession of the stock and sell the shares in the open market. But, of course, that assumes there is a reasonable bid/ask spread on the underlying stock. In many cases, if the spread on the option is excessive, it reflects a wide bid/ask spread on the underlying stock.

The options market is changing. And as a result, the new environment may require that you change the way you trade options. Whether you close a position before expiry or exercise rather than simply trade in the market, one thing is clear: in the future, successful options traders will be the ones who can adapt readily to change. IE