Option Expiration and Pinning
Options trading can appear intimidating to some traders. To make money, you must understand how option values fluctuate, the risks of option positions and the regulations pertaining to option expiration. You can have option positions that expire after periods ranging from one day to more than a year. Understanding the mechanics of option expiration will save you from unpleasant surprises.
Option Expiration
Long option position holders have the right to buy or sell (via calls or puts, respectively) a specified amount of some asset, such as securities, commodities, currencies and contracts, at a stated price – the strike price – on or before the expiration date (American-style options) or only on the expiration date (European-style options). An option seller – the short position – earns the option’s price, known as the premium, but may be forced to purchase or sell (because of puts or calls, respectively) the underlying asset should the option long position exercise the option. Call options can possess intrinsic value, which is any excess of the underlying asset’s price relative to the strike price. Put options gain intrinsic value when the underlying asset’s price is less than the strike price. Options also have time value that is based on their possibility of gaining intrinsic value. Time value decreases to zero by the time the expiration date arrives.
Unexpected Purchases
Most put and call long positions never exercise their options – they simply cash out by selling the option or, if out of the money, letting it expire worthlessly. However, if you don’t sell your options with intrinsic value before they expire, they will execute and you’ll end up buying (via calls) or selling (via puts) the underlying asset. Options expiration dates are on a Friday at the close of trading. Suppose you own seven stock calls with intrinsic value – in-the-money options – and neglect to sell them before they expire. On the following Monday, you’ll receive notice of your purchase of 700 of the underlying shares. If your brokerage account doesn’t contain sufficient cash to pay for the shares, your broker makes a margin call, meaning you must quickly deposit money or it will sell the underlying shares, forward the proceeds to the call short position holder and charge commissions (and possibly penalty fees) to your account. If this happens a couple of times, don’t be surprised if your broker closes your account.
Unexpected Assignments
A put short position who doesn’t repurchase an in-the-money put before expiration faces assignment. That means you’ll have to buy the underlying asset at the strike price, and if your account is underfunded, you’ll receive a margin call. A short position in call that expires in the money must deliver the underlying asset on the Monday after expiration. If you don’t already have the asset in your account, the broker will buy it for you using your margin deposit. Note that short option positions may be assigned before expiration, as long as they are in the money. You can sidestep problems regarding asset delivery and payment by closing an option position by the end of trading on the expiration date. It’s a good idea to leave standing orders with your broker to close out in-the-money option positions at expiration. This causes your broker to execute a market-on-close order, selling the options you own or buying back your short options. Either way, the broker closes your option positions and frees you from automatic purchase or sale of the underlying asset.
Pinned Stock Options
Pinning is the phenomenon observed on option expiration days in which underlying stocks tend to close right at a strike price of an option (closing at-the-money). This behavior is not seen on non-expiration dates nor for stocks without options. Pinning creates certain risks for both public option traders and for option market makers (OMMs) – specialist dealers who earn commissions by buying from public sellers and selling to public buyers, thus ensuring the existence of a liquid market for options.
Trading Risks
On option expiration date, a trader with a long position in ITM options will have a choice: close out the option position before the end of the day – receiving an amount of cash per option determined by the difference between the option strike price and the current stock price; or hold the position through the close and then receive (via a call) or sell (via a put) the underlying stock from/to the OMM. The risk of holding an option that is pinned near a strike price is that it could suddenly flip from ITM to out-of-the-money at the last second, leaving the option holder with a worthless position.
OMM Risks
OMMs in general wish to avoid holding outright positions in an option, because they do not want to undertake price risk – they make their money from commissions, not from gains and losses. Since OMMs must stand ready to buy and sell puts and calls, they prefer a neutral posture with respect to prices. This preference is what drives the mechanism of pinning on expiration day.
Mechanism of Pinning
As the market approaches its close on expiration day, ITM call holders may sell their positions to lock in a profit. OMMs are obligated to buy these calls, but do not want to take on the price risk associated with holding the calls. Therefore, OMMs will hedge away this risk by short-selling the underlying stock into the close, thereby neutralizing price risk – the short stock position loses value as the long option position gains, protecting the OMM from price moves in a strategy known as delta hedging. Short selling tends to depress prices by increasing supply, so stock prices that were above the strike price are pressured downward toward the strike. The reverse situation occurs for put holders when stock prices are just below the strike near expiration: if the put holders sell their options, the OMM will neutralize price movements by buying underlying stocks, resulting in upward stock price pressure. The see-sawing of offsetting pressures is why stock prices get pinned to option strike prices at expiration.
Tuesday, 20 December 2016