By: Steve Smith
As a 25 veteran as a professional trade, which included 6 years as a market on the Chicago Board of Options Exchange (CBOE), I feel pretty well versed in all the rules, nuances and potential pitfalls of trading. But this past Friday reminded me not only is there always more learn, but it’s even more important to make sure you the exact contract specifications that govern the instruments you are trading.
With the proliferation of products, such as ETFs, volatility related securities such as the iPath VIX Short Term Futures (VXX) and leveraged products there can be small but important differences. This is never more true than when it comes to rules regarding exercise and assignment, especially on an expiration day.
For example, most equity options are, including ETFs such as SPY, are American Style options meaning they can be exercised by the owner at any point prior to expiration. Most index and futures options, such as the S&P 500 Index, are European style and are cash settled. So you can see two very similar products such as the SPY and SPX have options that operate on different rules.
In my capacity of writing an option based newsletter I usually get a few questions every Friday such as “What happens if I am long options, and they finish in-the-money?” … “Will I be assigned.. etc?” which I have no problem answering. But this past Friday, I was woefully unaware of one aspect of SPY options, namely that they continue trading until 4:15 PM ET that created problems. This seems a good opportunity to walk through some common expiration-afternoon questions here and shed some light on the process.
First, the Options Clearing Corporation (OCC) automatically exercises options whose official close is one penny or more in-the-money. Those holding long calls would buy 100 shares for each call they owned after the close on Friday afternoon. Those with short calls might sell 100 shares for each call they were short as of the close. The short does not control the exercise.
For those long the options, it is your right whether or not you exercise these calls. If you wanted to, you could call your broker and ask to not exercise an option that finished slightly in-the-money. That way your option would expire worthless but you would not have to take delivery of the stock.
Again, note that your options that settle in-the-money on the close will be automatically exercised on expiration if you don’t proactively ask that they not be exercised. Conversely, if you are short options that settle in-the-money you must expect that you will be assigned and have the capital available to support the purchase (or shorting) of shares lest you get a margin call.
What happens if the stock price moves after 4 p.m. Eastern Time on Friday? Well, this is where it starts to get interesting. As any of you who trade in the after-hours market know, stocks continue to trade after the bell. Option strikes can move from out-of-the-money to in-the-money, or vice versa.
Trust me, the professionals in this market watch this very closely. They have approximately 1.5 hours after the close to make their decision on whether or not to exercise. The most common examples of this behavior are with ETFs like the Spiders (SPY) and the PowerShares QQQ Trust (QQQ) These options even trade through 4:15 p.m. Eastern, but the options are settled based on the 4 p.m. close. Because of this, you might be assigned on an option you are short when you don’t expect it.
This was the case this past Friday, the SPY closed at 4:00 at $203.15 per share. The 203 puts closed at $0.02 and seemingly had expired worthless. But the SPY options actually do continue to trade, along the SPT and S&P futures, for another 15 minutes. In the aftermarket shares of SPY, which has already experienced its worst day in months in the wake of the “Brexit” slipped another $1.00 to $202 and the value of those puts jumped back to over $1 a contract.
Needless to say many people who had failed to buy to close those puts before the close came in Saturday morning to find they had been assigned shares. This was a somewhat unusually situation for a broad based ETF to make such a large move after the close but there was the pending macro event.
The OCC rules state the owners of the option have a1.5 hours or until 5:30 PM ET to exercise their right to buy or sell shares. Many brokerage firms set a shorter deadline.
How can you avoid some of these corner cases? Well, you could close your positions before 4 p.m. Eastern. If you do this, there is no exercise or assignment risk. However, if you are short, you might be paying commissions and a small fee to buy back the options you feel will be worthless in almost every situation.
I think you should assess these case by case. Is there risk in being short calls in the SPY that are 10% out-of-the-money? Yes, but the odds of the market going up 10% in the 1.5 hours after the close are very remote. It is probably a risk you can live with.
The odds are much different if you are short options in, for a drug company with pending FDA approval or a takeover candidate or even more a volatile stock Netfllix (NFLX).
What happens if I exercise or get assigned options and take delivery of the stock? A lot of this depends on the size of your options trade vs. your account value. The biggest risk is you end up with much more risk than your account value can justify. You will have to close the stock position on Monday morning or bring in a lot of money.
Think about this scenario: you have $5,000 in your account. If you sold five of the 170/175 bear call spreads in Netflix Inc. for $3, you would have to post $2*5*100, which equals $1,000 (and leave the $1,500 you collected in premium in your account). So this trade takes up 20% of your account. This is probably a little too high, but within the realm of reality.
Your maximum risk of the options position alone is only $1,000. If you leave the trade on until expiration and the stock closes at $171, however, theoretically you should be happy. The spread was worth $1 at expiration and you originally collected a net credit of $3, so your profit is $2. However, if you did not close the spread, your trade is far from over. You will be assigned on the $170 calls and the $175 calls will not be an exercise.
On Monday, your account will be short 500 shares of NFLX. That is $85,500 worth of short stock!!! Margin on this trade is $51,300. Your account probably has $6,000 in it. On Monday morning, you have a couple of choices: first, if you have $45,300 laying around, you can wire it into your account and keep the short position.
This does not mean the brokerage will automatically close all your positions, they want to minimize the losses too, but you will need to do something within a relatively short period of time. As in by the first few hours of trading on Monday.
The upshot I, always read the contract specs and check with your broker for their specific rules before buying or selling an options. Especially come expiation day.