Five Things to Watch Going into Options Expiration

11/17/2010 12:01 am EST

Focus: OPTIONS

Mark Wolfinger

Educator, MDWoptions

Options expiration is an exciting time for traders. As the time to expiration day disappears, the value of an option portfolio becomes increasingly volatile. If you are a more conservative trader, it might be better to exit your trades before expiration draws too near.

But, if you think you’re up to the challenge and want to play in this arena, then you’d better know what you are doing. There are certain situations that can amplify or crush the value of your positions. Here are five things you need to pay special attention to as expiration Friday approaches. These situations can amplify or crush your options positions.

1) Risk vs. Reward

Expiration plays come with higher risk and higher reward. In return for paying a relatively low price for an option, buyers have only a short time for the market to work its magic. Otherwise, the option expires worthless.

Many new traders believe they are locked into a trade once it has been made. That’s not true. You are allowed to sell those options any time. But don’t sell them for a tiny premium, say five cents. For that price, take your chances. But when real cash is at stake, say $1 or so, then the decision is more difficult.

Although it may seem like an obvious warning, when buying options near expiration day, please be aware of what must occur for you to earn a profit. Then consider the likelihood of that happening. The same warning applies to option sellers. Time may be short, but when the unlikely occurs, the loss can wipe out years worth of profits. When there’s just too little premium to justify the risk, then cover the short position and leave the last bit of cash on the table. 

2) Option Greeks

Traders need to be especially mindful of their option Greeks, specifically delta and gamma, around expiration. As expiration approaches, an option’s value can change dramatically in a very short time. Delta measures the rate of change in an option’s price as it relates to movements in the underlying asset. Gamma measures the rate at which an option’s delta changes.

Gamma increases as expiration approaches, and when gamma is high, delta can move from near zero (out-of-the-money (OTM) options) to almost 100 (in-the-money (ITM) options) quickly. When that happens, option owners can earn a bunch of money in a hurry, and option shorts can get hammered. However, those short-lived options can become worthless fast. In short, having an at-the-money (ATM) (or not-far-OTM) position is treacherous, and reducing the size of your position is a healthy and simple method for reducing risk.

3) Increased Volatility

Volatility tends to increase as expiration draws nearer. Traders must pay special attention to volatility—both volatility of the underlying stock or index and the implied volatility of the options themselves. For option owners, volatility is your friend. The fact that stocks are more volatile is enough to raise implied volatility, and that in turn increases the value of your options—sometimes by more than the daily time decay. If you get lucky twice and the underlying stock moves your way, the option’s price may increase many times over. 

For option sellers, however, increased market volatility translates into fear. Whether a trader has naked short options (essentially unlimited risk) or short spreads (limited loss potential), he/she must recognize that the underlying asset can undergo a large, rapid price change. Options that seemed safely out of the money and a “sure thing” to expire worthless are suddenly in the money and trading at hundreds (or thousands) of dollars apiece.

When an index moves 5% in one day (as it did frequently during late 2008), S&P 500 (SPX) options that were 40 points OTM in the morning were ten points ITM by day’s end. When that happens with an increase in implied volatility, losses (and gains) can be staggering. There is good reason for the shorts to be afraid. One good risk management technique is to buy back those shorts whenever you get a chance to do so at a low price. Remaining short with the hope of collecting every last penny of premium is a high-risk game.

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4) News Events

If you plan to trade options close to expiration, please be aware of any pending news events, such as a quarterly earnings report, that could affect the underlying stock. When news is released, the underlying stock often undergoes a substantial change in price, and when this occurs near expiration, the expiring options add fuel to the fire thanks to gamma.

So, if you have a position, or are considering opening a new position, be certain that you know whether news is pending. If you are a risk avoider, don’t hold short options with negative gamma in the face of earnings releases.

5) Margin Calls

Receiving an unexpected margin call is one of those unpleasant experiences traders should try avoid. At the very least, margin calls are inconvenient, and most result in a monetary loss, even if it’s only from extra commissions.

When you hold an in-the-money (ITM) short option position, there is the possibility of being assigned (and converting an option position to stock) an exercise notice. Early exercise is unlikely unless the option is deep ITM. However, any option that finishes ITM is subject to automatic exercise. That means your chances of not receiving an assignment are essentially zero.

Exiting the trade prior to expiration makes it likely (there is still the chance of being assigned before you exit) that you can avoid the margin call. Most put sellers sell puts only when cash secured (i.e., the cash to buy shares is already in the account). When cash is available, there is no margin call. Those who write call options are subject to the same assignment risk. If the trader is covered, there is no problem. Upon assignment, the shares already owned are sold to honor the option seller’s obligations.

When you receive a margin call, many brokers (without warning) sell enough securities (to generate cash) to meet that call. Other brokers automatically repurchase your short options (with no advance warning) before expiration arrives. Bottom line: When you cannot meet the margin requirement, do not hold a position that is subject to early exercise. And never hold that position through expiration (when assignment is guaranteed). Find a way to exit the trade to avoid possible margin calls.

By Mark Wolfinger of Options for Rookies

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