How To Trade Options On Expiration Day

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Expiration Day Trading
My favorite day of the month is almost here again. While all summer Fridays are good, expiration Fridays provide some unique trading opportunities. Unfortunately for me, I'll be away for a long weekend and since the beach and my computer don't get along, I've closed out all my options that will expire soon.

Sell the longs and buy back the shorts. Even though many of them would have expired worthless, it's worth a few bucks to have peace of mind. Since I won't be able to watch the market and I won't be able to trade, closing my positions doesn't leave anything to chance.

Expiration is also the time of the month when market makers make some "bonus" money. This bonus comes from public traders who do not know how to properly exit their positions and leave nickels, dimes or more for the market makers. Since I'm going to tell you how to avoid this little trap, Options Insider readers will have yet another advantage over other options traders.



Example 1 - Calls
Let's assume that you own an XYZ July 45 Call option and just before expiration that XYZ is trading at $49. The value of your Call should be equal to parity, or $4. In actuality, the market for the Call may be something like, $3.90 bid, offered at $4.10.

Now let's digress for a moment and look at this situation from the eyes of the market maker. If he can buy the Call for $3.90, he will immediately sell (if he has inventory) or short the stock at $49. Then at expiration, the Call will be exercised, so the market maker will end up effectively paying $48.90 for the stock. The $3.90 he paid for the Call plus the $45 exercise price.

Since he also sold the stock for $49, he is left with a flat or zero stock position, and a $.10 profit. Remember that the transaction costs for a market maker are minimal. So that's almost $10 profit for each option contract, with no risk. Now $10 may not sound like much, but believe me, with the volume of contracts being traded today, that could be a very nice day's work!

Okay, back to your situation. If you do nothing, then the option will be automatically exercised at expiration and when you wake up Monday morning you will have 100 shares of XYZ stock in your account for each option contract you owned. Now you're subject to unwanted market risk; not good.

The alternative is to do basically the same thing that the market maker would do. Near the close of trading, short the stock and then let the Call be automatically exercised. You will end up getting out at parity, having a flat stock position, and not having any market risk over the weekend. Sleep well!

Example 2 - Puts
How's this work for long Puts? Almost the same way, except in this case, instead of selling the stock, you would have to buy it. For example, with XYZ trading at $49, the XYZ July 60 Put might be $10.70 bid, offered at $11.30. If you closed out the position by hitting the bid, you would only get $10.70 for your Put which is really worth $11.00.

So buy the stock at $49 and exercise the Put. If you work through the numbers, you'll see that you're effectively getting the full $11.00 for your Put. You should note that in either the long Put or Call situation, you will have to pay commissions to buy or sell the stock. Even so, with commissions being as low as they are today, saving even 5 cents on 4 or 5 contracts makes sense.

Margin & Automatic Exercise
If you're thinking that there may be margin problems in either the Put or Call scenario, you probably can stop worrying. There is something called an "irrevocable exercise notice." This is what allows you to be able to buy or sell the stock without putting up any margin, because you are in effect guaranteeing that you will close the position (via exercise of the option) the same day.

Many brokers will see that your ITM option will be exercised and you won't actually have to tell them that you are making this irrevocable election. However, if they ask, that's what you tell them. If they ask, and then don't know what you're talking about (I've heard stories like that) you may want to find a broker who does.

Naked Short Options
What about naked short options, how do you close them out at expiration without taking a beating? The concept is again similar, except in this case, you don't have control of the situation. Remember, you may be assigned on a short option, but it's not 100% guaranteed.

Even with the automatic exercise rules providing that options that are ITM by even 1 penny will be exercised (and that you will therefore be assigned) the holder of a long option position that is only slightly in the money may request not to have his options exercised.

The probability of this happening is remote, but because it is possible your broker will probably require margin for a stock trade done in anticipation of assignment. So if your account has the available margin, then you can close out the naked position by buying stock for Calls, and selling (shorting) stock for Puts.

If you don't have the margin available, you might have to bite the bullet and buy the options back from the market maker. It will be instructive for you to think through the process.

to be continued in Part Two...

posted by: Stan Freifeld
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