A question I get asked quite often is – “what happens if you don’t close an option position before expiration?” Well don’t worry, it’s not all doom and gloom. It’s really quite simple. First off I’d like to cover a few basic terms and definitions.
Options get exercised automatically if they are in-the-money and you don’t opt specifically not to exercise the options.
What this means is that you options will be converted into shares and you will become a proud stock owner!
So for example say you bought a $235 strike call on Amazon (AMZN) on expiration Friday for 0.80 cents. Towards the close Amazon stock when up to $240. If you do nothing at the close (i.e. don’t sell your options to close the position) then your options will be exercised.
When does options exercise take place?
So what time does options exercise officially take place? Options exercise takes place officially on Saturday night. I’m not sure exactly what time, but I think it’s at 23:59.
What problems can there be with options exercise?
One potential problem with options exercise is that you can potentially be required to buy a very large dollar amount of stock. Owning stocks takes up a lot more capital than owning options. So for example if you were planning to trade with your 80 cent options on the AMZN $235 strike, you only need to put up a small amount of capital for this trade (80 cents X 100 options = $80 per contract). If for example you buy 10 contracts, you need to outlay $800.
Now if for some reason you don’t close off this position before expiration then you can be potentially obligated to outlay a lot of money to buy Amazon stock. Specifically in this example you own 10 contract each with 100 options. So you would be obligated to buy 1,000 AMZN shares at $235 (the strike price). That comes out to a whopping outlay of $235,000!
What can you do if you don’t close off an options position before expiration?
Firstly don’t panic! You won’t (necessarily) need to outlay the $235,000 if you’re smart about it.
A nifty trick if you don’t manage to close an options position before expiration!
There is a nice trick that I learnt from my broker regarding what to do in just such a situation. It involves a little something called “Extended hours” trading.
Extended hours trading, or more specifically after hours trading, occurs from 4pm to 8pm after the market close. In the past this was only the domain of institutions and professionals. However recently it has become accessible to private investors through most good brokerage firms.
So in this example, let’s say you didn’t manage to close off your position and realize your profit on the options before market close. One options is of course to exercise your options and buy or buy on margin $235,000 worth of AMZN stock at $235 per share.
The really bad thing with the above options, apart from the very large outlay, is that you expose yourself to a large directional risk. This is okay if it was part of your original strategy. However if your initial strategy was direction neutral, it really ain’t okay! That’s taking on a huge directional risk. If on Monday the market drops and AMZN trades below $235 you won’t realize any of the paper profits you saw when AMZN traded at $240 before the close on Friday.
The best option is to do the following: In the extended hours trade go short the equivalent amount of AMZN shares. In this example you would go short 1,000 AMZN shares at $240. The most important effect is that it will lock in your profit of $5 since you short the shares at a predetermined price ($240) and you know the exercise price (or essentially your buying price for the shares) which will be the strike price of $235.
On Saturday night, the minute your options are exercised your short position will be closed. This is because options exercise is essentially the same as buying the same amount of shares.
So again, just to emphasize, this is an amazing strategy since you get to lock in your profit that you made on the option trade, you don’t take on any directional risk and you don’t need to lay out the capital to purchase the shares.
Since I trade around expiration using options, it’s happened to me several times that I’ve had to use this strategy to close the trades. It works!
In general there are some disadvantages of extended hours trading that you should know about. For most stocks there is much lower liquidity, price changes tend to be more volatile and usually you can only carry out limit orders.
If you have any questions about this scenario feel free to ask me about it (either using the comments below or send me mail via the “contact” page). Alternatively ask your broker – most should be able to help you.