It’s options expiration day and time to decide what to do with your current positions, right?
If you sell options, expiration day is probably an anticipated event. When you buy options, it’s usually something to dread.
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 5 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 to take a long-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!
The majority of people trade American-style options.
However, some investors prefer European-style options, so we want to make sure that everyone knows the differences between the American- and European-style options.
Most options that you and I will trade are American-style options, 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 any time before expiration.
This is JUST for exercising purposes and doesn’t mean you’re “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.
To help you avoid confusion, I think it would be prudent for me to point out a few key differences between American and European-style options:
- First, the time when trading ceases is different for American and European options. As you possibly know, when you get to the expiration month, American options cease trading on the third Friday, at the close of business. There are exceptions though. For instance, at the calendar quarter, quarterlies cease trading on the last trading day. European index options, on the other hand, stop trading on Thursday, preceding the third Friday of the expiration month. Take note of this, since that’s a whole day earlier than the American option.
- Unlike American options, the settlement price for European options isn’t a real world price. Instead, calculations from trade data from Friday’s early trading day are used to determine the final settlement price. Such a settlement price is what determines the options that are in the money. Hence, you should be increasingly careful not to assume that the Friday morning index price reflects the settlement price. For this reason, it would be far safer to exit your position by Thursday afternoon when dealing with European options.
3. Don’t Hold Positions to the Last Minute
Let’s face it. Letting go is the hardest part of trading.
Have a look at these two possible scenarios. You have a losing trade but you still don’t want to give it up because you think you “could” make money at the end of the day. Conversely, you have some money on the table in profits but you think you still stand a chance to make more money before options expiration.
Just to let you know, the last couple of days are the worst time to exit trades because of the increased gamma risk. This means that an option’s value will swing faster in both directions during these final days until expiration. As such, 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 as profit. Honestly, we should start having expiration day parties!
4. Check Option Open Interest
Most traders do not take 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.
Bonus Tip: Consider Rolling Your Option Position
Some investors are adamantly convinced that stocks are better than options, simply because options expire. However, that can be easily dealt with by rolling your option position.
You shouldn’t fall into the trap, like many other traders, of losing out on your winning streak as time runs out and when the expiration date draws closer. You can still take advantage of your winning position especially if the position looks likely to continue in your favor.
Using a technique known as “rolling”, you can lock in your profits in a favorable position and benefit from additional upside. This is something you can actually do even before expiration week, whether the expiration date is five, three, or two months away. It would certainly be far better to take advantage of it earlier than later.
Rolling helps you bank your profits. You can then use your original investment capital to buy another option with a further-away expiration month. In this regard, consider whether you have calls or puts. With calls, “roll up” to a higher strike price especially if the stock keeps rising. In the case of puts, “roll down” to a lower strike price.
This is something you can do continually while your stock keeps on running (for calls) or falling (for puts).
Using this technique, you’ll be limiting your risks while locking in your profits. Best of all, you’ll also maintain the same-size position. Apparently, this is a benefit unique to options and thus not found with any other security. It’s no wonder options make such attractive investment opportunities.