apple option (Photo credit: Gideon Tsang)
Last Friday, on expiration day, we had one of the greatest nightmares for options buyers come to fruition. Whether you were long Calls or Puts, it was as traumatic as a fight scene from a Quentin Tarantino movie. The situation I am referring to is known in the options world as being “pinned”, and it did not mean that you were on your way to a 300 perfect score à la the late, great bowler Earl Anthony. In fact, this pin is more like rolling a gutter ball, as it refers to a situation in which a stock closes at a strike price on expiration day. The good part is that it represents a teachable moment for buyers and sellers of options.
First, a quick refresh. If you purchase an option, you have the right to exercise it (with an American style option as most equities are) at any time in the expiration cycle. In simple terms, you can exercise your right to purchase the stock at the strike price (call away) with a Call and you have the right to sell the stock at any time (put to someone) at the strike price at any time by purchasing a Put.
On the other end of this trade, if you are a seller of options, you have the obligation to buy the stock at any time if you sell Puts, and sell the stock at any time if you sell Calls. I’m not saying it is necessarily better to be a buyer or seller, but most new traders are buyers as then they are in charge of their own destiny. Either way, understanding the risks and potential rewards is essential.
As you can see in the graphic below, Apple (AAPL) shares closed right at $500 Friday afternoon. Notice the Theoretical Value (Theo Price) is $0 on both $500 Calls and $500 Puts. Yet, people were willing to buy both for more than they were theoretically worth at market close.
For many, this would seem counter intuitive, paying more pay more than the actual value, but even though it did not have any value, the person who purchased it could still exercise the option. In other words, if a person holding a $500 Put wanted to be short stock on Monday morning, they could simply exercise the $500 Put and on Monday morning they are short stock to start the day to the amount of options exercised. On the other hand, if you are short those options, it is worth “paying up” to be out of the risk on that position.
As you can see, investors were willing to pay $.07 for the Calls and $0.25 for the Puts. This is particularly notable as it implies that the market saw more risk to being short Puts over the weekend than it did being short Calls at this time. Theoretically, the risk should be the same.
You may be thinking this only happens to stocks such as an AAPL that have incredible volume, or that something fishy is at work, but that is far from the truth. In fact, it can happen in any stock. Take Alcoa (AA), for example.
On the same expiration day that AAPL pinned $500, we saw AA pin $9. Why does this happen? It happens as those that are long options (see long gamma) are forced to sell stock as the stock goes above the strike and buy stock as the stock goes below the strike. This pressure around the strike as we get closer to expiration has an effect of often pinning a stock to the strike price.
So what can you do to avoid being in a situation in which you are at risk? The key to position management in these trades, as with any trade, is discipline. In trading options, many traders like to consider closing their positions 4-10 calendar days before expiration, particularly if on the short side of a trade. If on the long side of the trade, the difficult part is that as time passes, and particularly during expiration week, the time decay begins to happen exponentially (see Theta). Therefore the value of the option is theoretically becoming less and less each day.
As you look at this from a short option point of view, you see nothing but positives in the decay. However, you are not in control of your own destiny and you do not necessarily want a stock position that you are now obligated to if that was not your original intent. One of the other things you will notice is that in many cases it makes very little mathematical sense to exercise before this time frame. The closer you get to expiration, the more options will make sense to exercise early. If getting assigned to be long or short stock was your intent, great. But for many, it was not and it can put them in a very gut-wrenching situation, which can lead to bad decisions.
In the end, cleaning up your options positions can help you make better decisions, keep you in control of your own destiny and hopefully lead to greater profits over time.
For more from J.J. Kinahan, follow him on Twitter, @TDAJJKinahan.
Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Options.
Commentary and examples provided for educational purposes only. Should not be considered a recommendation for any specific security or strategy. Supporting documentation for any claims, comparison, statistics, or other technical data will be supplied upon request.
