After Steve Claussen and I wrapped up our weekly webinar on expiration risks , I thought it might be helpful to highlight what we discussed and offer a couple of other important pointers to remember for this monthly (and now weekly and quarterly) event. Expiration for professional traders is a time to reduce risk and unwind any trades that could be “unknowns” going into expiration Friday.
The third Friday of each month is also a time to look ahead to what positions will be kept open through Monday morning. Finally, it is the time to make decisions on whether to “roll” open trades. This basically means buying or selling a spread to extend an open position to the next month (or beyond).
“Unknowns”
When I use the word “unknowns,” I am mainly referring to options positions, both long and short, that are at-or near-the-money. The term “Pin-Risk” directly applies to options expiration. Pin-risk is the phenomenon where the underlying stock “pins” right at a strike. For professionals, there are advanced tactics like converting or reversing to neutralize pin-risk.
For the average retail trader, generally the real risk is associated with shorted options, which give the seller NO control over whether their options will be exercised or not. The stock doesn’t even have to “pin” a strike to create complications at expiration.
This risk may either be naked short options or (perhaps even more dangerous) short options that are part of a spread. Traders may find themselves in situations where they do not have the funds available to cover, nor do they have the intention of ultimately being long or short the stock.
Expiration Risk Example
If you were short 20 (uncovered) IBM 130 calls and IBM stock closed at $130 on Friday afternoon, you have no way of knowing if these calls will be assigned or not. The Options Clearing Corporation (OCC) stipulates that any option that is one cent in-the-money or greater will be automatically exercised, unless the buyer specifically specifies he does not want them to be exercised. So even if IBM were to close at $130.05, there is still some chance that some or all of your short calls will NOT be assigned.
But what if IBM closes at $129.90? Anyone who sold the 130-strike calls is probably pretty happy. Let’s say you decide to let your calls expire instead of buying them back for three cents each (the offer price at 4:00 pm ET).
At 4:05 pm, you run out for a round of golf since the market is closed and it’s the weekend. At 4:20 ET, Intel issues a forecast for higher-than-expected PC sales. This report sends IBM shares higher in sympathy and the shares are now trading at $132.00 in post-market trading.
While you’re out golfing, the buyer of those calls, which are now in-the-money by $2.00, exercises all of them. Your broker notifies you of this on Saturday and come Monday, you are short 2,000 shares of IBM at $130. IBM opens Monday at $135 on the good news from Intel … this is not good news for the short call holders!
What would have cost you three cents a contract…