TD Ameritrade | Jun 30, 2022 03:20AM ET
So your trading account has gotten options approval and you recently made that first trade—say, a long call in XYZ with a strike price of $105. Then the option expires, and at the time, XYZ is trading at $105.30.
Wait. The stock’s above the strike. Is that in the money (ITM) or out of the money (OTM)? Do I need to do something? Do I have enough money in my account? Help!
Please, please, please: Don’t be that trader. The time to learn the mechanics of options expiration is before you make your first trade. Opening an account at TD Ameritrade entitles you to a host of free trading education, including an entire course on options trading. (And at the end of this article, you’ll find a short video covering the basics.)
Here’s a guide to help you navigate options exercise and assignment — along with a few other basics.
h2 Memorize This Table (or Cut It Out and Paste It to Your Screen)/h2The buyer (“owner”) of an option has the right, but not the obligation, to exercise the option on or before expiration. A call option gives the owner the right to buy the underlying security; a put option gives the owner the right to sell the underlying security.
Conversely, when you sell an option, you may be assigned the underlying asset—at any time regardless of the ITM amount—if the option owner chooses to exercise. The option seller has no control over assignment and no certainty as to when it could happen.
An option will likely be exercised if it’s in the option owner’s best interest to do so, meaning if it’s advantageous from a price standpoint for the owner to take or to close a position in the underlying security at the strike price rather than at the prevailing price in the open market. After the close on expiration day, ITM options may be automatically exercised, whereas OTM options are not and typically expire worthless (often referred to as being “abandoned”). The table below spells it out.
This assumes a position is held all the way through expiration. Of course, you typically don’t need to do that. And in many cases, the usual strategy is to close out a position ahead of the expiration date. We’ll revisit the close-or-hold decision in the next section and look at ways to do that. But assuming you do carry the options position until the end, there are a few things you need to consider:
But it goes beyond the exact price issue. What if an option is ITM as of the market close, but news comes out after the close (but before the exercise decision deadline) that sends the stock up or down through the strike price? Remember: The holder of the option could submit a Do Not Exercise request.
This uncertainty and potential exposure is called pin risk, and the best way to avoid it is to close your position before expiration.
h2 The Decision Tree: How to Approach Expiration/h2As expiration approaches, you have three choices. Depending on the circumstances—and your objectives and risk tolerance—any of these might be the best decision for you.
Let the chips fall where they may. Some positions may not require as much maintenance. An options position that’s deeply OTM will likely go away on its own, but occasionally an option that’s been left for dead springs back to life. If it’s a long option, that might feel like a windfall; if it’s a short option that could’ve been closed out for a penny or two, you might be kicking yourself for not doing so.
Conversely, you might have a covered call against long stock, and the strike price was your exit target. For example, if you bought XYZ at $100 and sold the 110-strike call against it, and XYZ rallies to $113, you might be content with the $10 profit (plus the premium you took in when you sold the call, but minus any transaction costs). In that case, you can let assignment happen.
Close it out. If you’ve met your objectives for a trade—for better or worse—it might be time to close it out. Otherwise, you might be exposed to risks that aren’t commensurate with any added return potential (like the short option that could’ve been closed out for next to nothing, then suddenly came back into play).
The close-it-out category also includes ITM options that could result in an unwanted position or the calling away of a stock you didn’t want to part with. And remember to watch the dividend calendar. If you’re short a call option near the ex-dividend date of a stock, the position might be a candidate for early exercise. If so, you may want to consider getting out of the position well in advance—perhaps a week or more. Keep in mind, there is no guarantee that there will be an active market for an options contract, so it is possible to end up stuck and unable to close an options position.
Roll it to something else. This is the third choice. Rolling is essentially two trades executed as a spread. One leg closes out the existing option; the other leg initiates a new position. For example, suppose you’re short a covered XYZ call at the July 105 strike, the stock is at $103, and the call’s about to expire. You could roll it to the August 105 strike. Or, if your strategy is to sell a call that’s $5 OTM, you might roll to the August 108 call. Keep in mind that rolling strategies can entail additional transaction costs, including multiple contract fees, which may impact any potential return.
h2 The Bottom Line on Options Expiration/h2You don’t enter an intersection and then check to see if it’s clear. You don’t jump out of an airplane and then test the rip cord. So do yourself a favor. Get comfortable with the mechanics of options expiration before you make your first trade. Your beating heart will thank you.
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