It’s options expiration day and time to decide what to do with your current positions right?
Either way, there are things you must know, and steps you should take, to avoid any unpleasant surprises on the third Friday of each month.
Here are our Top 4 MUST-KNOW traps to avoid during this volatile time and some pointers for handling any crazy positions…
#1 Don’t Exercise Your Long Option
You really shouldn’t consider exercising options at expiration – it’s just not worth it unless you are a big “fan” of the stock and company.
Unless you bought a call or put so that you could take a longer term position in the stock you are generally better off closing the option trade than purchasing the shares.
In addition, exercising options come with additional broker commission fees that you don’t want or need to pay.
#2 European Options Are Different (Watch Out)
A majority of the 30,000+ people who frequent this blog daily trade American style options.
However, we do have visitors from a lot of the major countries all over the world. So we wanted to make sure everyone knew the differences between American and European style options.
Most options are American-style options that you and I will trade and all the rules you already know apply to them. However, some options are European style (and no, they do not trade only in Europe) which have slight variations.
Most index options are European style exercising. European style exercising means that you can ONLY exercise that option AT expiration vs. American when you can exercise the option at anytime up until expiration.
This is JUST for exercising purposes and doesn’t mean that you are “stuck” in a position until expiration.
These are index options and not ETF options I’ll remind you, so the SPDR S&P 500 (NYSE: SPY), PowerShares QQQ Trust (NASDAQ: QQQQ) and iShares Russell 2000 Index (NYSE: IWM) are all American-style options.
#3 Don’t Hold Positions To The Last Minute End
Letting go is the hardest part of trading.
You have a losing trade and you don’t want to give it up because you “could” make money at the end of the day right? Or you have some money on the table in profits but you “could” make more money right?
Either way the last couple of days are the worst time to exit trades because of the increased gamma risk. This means that an options value will swing faster in both directions the last few days until expiration. Profits can evaporate overnight.
Let some other guy trade those last couple of pennies in value praying for the “big move”.
Of course if you’re a net option seller like us, option expiration is a great time! We just let our positions expire worthless and keep the entire premium we collected at expiration as profit. Honestly we should start having expiration day parties!
#4 Check Option Open Interest
Most traders don’t take the time to check out option open interest.
This is the number of open contracts for both puts and calls in a given month. The theory behind this is that the more “overlap” there is in the strike prices, the more likely the market will tend to trade towards that level at expiration.
Since we know that most contracts expire worthless at expiration, it’s safe to assume that the market will move into an area that causes the “most pain” for option buyers.