It is critical for options traders to keep their eye on the ball \u2014 from the inception until the very end of every position they take in the market \u2014 or they can be exposed to far greater risk than they intend.
Let\u2019s consider the example of an options trader we\u2019ll call Mr. S.
He bought 10 Google Inc. October 460 puts in September. On Oct. 19, the last day of trading, he tried to sell the puts at a limit price. He was unable to do so, however, and decided to let the options simply expire worthless.
Most investors believe that when they buy a call or a put option, the most they can lose is the cost of the option. After all, limited risk is one of the advantages of trading options on volatile stocks such as Google.
Such limits only work, however, if the trader is willing to exit the position prior to expiration. If the option is exercised, the trader ends up either being long or short the underlying stock. That means the trader now assumes the same risk as any other stockholder, as a stock could decline to zero or rise to infinity.
In the case of Mr. S, his decision to let the option expire left him vulnerable to \u201cautomatic exercising.\u201d
In the U.S., the Options Clearing Corp. <\/b> has provisions for the automatic exercising of certain in-the-money options at expiration. For the record, options expire on the Saturday following the third Friday of the expiration month, so even if an option ceases to trade at the end of trading on Friday, it still exists as a legal entity until the next day.
On the Saturday following the third Friday, the OCC implements a procedure referred to as \u201cexercise by exception.\u201d This means the OCC will automatically exercise any expiring equity call or put in a customer account that is 5\u00a2 or more in the money.
The criterion used to be 25\u00a2 in the money, but was reduced prior to the October expirations. The same applies to an index option that is 1\u00a2 or more in the money.
In our example, Google stock closed at US$459.67 a share on Friday afternoon, which means Mr. S\u2019s options were automatically exercised by the OCC on his behalf. On Monday morning, Mr. S was surprised to learn that he was, because of the automatic exercising, short 1,000 shares of Google at US$460 a share.
As it happens, that was about the same time that Google announced its earnings, and the purchase of www.YouTube.com. As traders digested the news over the weekend, Google shares jumped sharply on the following Monday, and Mr. S was forced to buy back his short position at US$78 a share, for a loss of US$18,000.
That is, of course, in addition to any loss that occurred on the Google puts.
Clearly, Mr. S should not have had to go through the aggravation. He could have asked his broker not to exercise the option, regardless of whether it was in the money or not. He also could have simply closed out the position through a sale prior to the close of trading.
The situation is an interesting case study about the importance of overseeing your options trading from inception to expiration. It also raises a series of questions that, at some point, the brokerage industry is going to have to address.
In the example, Mr. S ended up with a US$460,000 short position in Google. Although he had sufficient capital to buy the option, he did not have sufficient margin to maintain a short position in the stock.
Which raises another question: is the brokerage firm at risk if it automatically exercises an option into an account that clearly does not have enough margin to support the position after exercising the option?
So far, this has not been challenged. If it were, I would assume brokers would rely on the disclosure language in the options risk disclosure statement. Still, there is also a fiduciary responsibility that I suspect at some point may be challenged in the courts.
There are also examples of options that expired out of the money but, with after-hours trading, ended up in the money.
In the Google example, let\u2019s suppose that the stock traded higher in after-hours trading to, say, US$462 a share. At that price, traders who were long will say the October 460 calls expired worthless based on the 4 p.m. closing price of US$459.67, but would now have some intrinsic value.
@page_break@Would the call buyer have had the options exercised automatically?
The answer is no, because automatic exercising is driven by the value of the underlying stock at the 4 p.m. close of trading. Traders, can, however, request that options be exercised even if the stock closed at a 4 p.m. price that is out of the money. Each brokerage firm has what is known as \u201ccut-off times\u201d to send exercise instructions to the OCC.
Investment advisors who advise clients on options should be clear on the exercise procedure and their firm\u2019s appropriate cut-off times. \t IE<\/b>
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It is critical for options traders to keep their eye on the ball \u2014 from the inception until the very end of every position they take in the market \u2014 or they can be exposed to far greater risk than they intend. Let\u2019s consider the example of an options trader we\u2019ll call Mr. S.He bought […]<\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":[],"categories":[3013,3029],"tags":[],"yst_prominent_words":[],"acf":[],"_links":{"self":[{"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/posts\/328807"}],"collection":[{"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/users\/4"}],"replies":[{"embeddable":true,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/comments?post=328807"}],"version-history":[{"count":1,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/posts\/328807\/revisions"}],"predecessor-version":[{"id":361738,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/posts\/328807\/revisions\/361738"}],"wp:attachment":[{"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/media?parent=328807"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/categories?post=328807"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/tags?post=328807"},{"taxonomy":"yst_prominent_words","embeddable":true,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/yst_prominent_words?post=328807"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}