By Mike Tibbits, YouCanTrade
Trading options gives you the right to buy or sell the underlying security for a specific price before the option expires. The closer an option gets to its expiration day, however, the faster it loses value. Therefore, buying options on expiration day is extremely risky and is not for the faint of heart.
You are Battling Against Time
As we just mentioned, the closer an option gets to its expiration day, the faster it loses value; this is known as time decay. Options typically expire at the close of the market on the day of expiration, which is usually Friday.
(Note: There are some index options which expire on Thursdays. Options on certain exchange-traded funds like SPY, have Monday, Wednesday and Friday expirations.)
When you buy an option on expiration day, the time value of the option is quite small because the option is expiring so soon. That is why an option, once it is in-the-money, tracks closely to the underlying stock price. An in-the-money option will only be worth the difference between the strike price and the close of the underlying asset. Out-of-the-money options will be worth $0.
Sideways Markets are No Bueno (that’s Spanish for not good)
If you are long calls or puts and the market is moving sideways, guess what? You are losing money! The longer you wait for the market to take a direction, the more it will have to move to make up for the time you have wasted. I know it’s cliché, but this is the perfect time to say “time is money.”
Option prices can change… and they can change fast!
Watching option prices change the day of expiration can be eye opening, especially if it is a volatile trading day. As the underlying asset whipsaws above and below the strike price of the option throughout the day, the value of the option can easily shift up and down in double digit percentages. You could easily go from being up 15% to down 40% in a matter of minutes depending on what price you paid. This makes risk management very difficult because the probability of being stopped out prematurely is much higher.
Beware 3 pm Eastern
Some brokers might begin closing in-the-money option positions in accounts that would not be able to afford to take on the underlying positions when exercised. Although the time varies by broker, they generally begin closing positions out sometime around 3:00pm EST on the day of expiration. If this is not what you desire, you should call your broker’s trade desk department and find out what your options are… (See what we did there?)
Close your trade before expiration
You opened your option position to make a profit and now your options are about to expire. If you have a profit, you might feel tempted to keep the trade open a little longer to make a little more money. If you have a loss, you might think if you hang on a little longer, you could take less of a loss and make some of your money back.
Unfortunately, the odds of making a few more bucks are against you. To protect your trading capital, close out your option trades and take your profit or loss before your options expire. Even though it stings, losing 75% is better than losing 100%.
Close in-the-money options before expiration. That’s right. We said it twice.
Now… you might be thinking, why do I have to close my option position if my broker is going to do it anyways? The reality is your broker is not going to babysit your account for you. They can’t get to everyone and will prioritize closing in-the-money options in accounts that pose the most harm to the firm should those options be exercised. So, if you know you can’t afford to take a position in the underlying stock, you are better off closing any in-the-money option positions before the market closes.
But just for fun, let’s see what would happen if you didn’t close your trade before expiration.
Let’s say you are long one 50-strike call option and the stock closes at $50.01. That means your option is in the money by one cent. Generally speaking, all options that are in the money at expiration are automatically exercised. So come Monday morning, you will own 100 shares of stock at $50/share. That’s a $5,000 position you are responsible for. You will get a margin call from your broker if you do not have enough money in your account to pay for the stock, and you will be in debt. What’s worse is if on Monday the stock gaps down and opens at $45, you would be down an additional $500.
Fun right? – This is why we’re telling you twice.
What if I forgot to close out my in-the-money option?
As a last resort, you can attempt to contact your broker and request a Do Not Exercise (DNE) so you don’t take on an unwanted stock position. However, you have to act within the broker’s specified time clock, which may be on the last trading day prior to expiration.
Learn more about options with our on-demand course, Start Trading Options. This in-depth beginner course cuts through the confusing pricing concepts and jargon to explain what you need to know to place your first options trade with confidence. Learn more.