Saturday, February 6, 2021

Options Trading: The Worst Case Scenario

TLDR: Traders are swallowing far more risk than they think by not closing out the short legs of their defined-risk out of the money spreads at expiration. 

When it comes to options trading, I don't think many traders understand or appreciate the risks they're potentially exposed to following the close on options expiration day. This is especially true for traders who trade a lot of spreads, especially credit spreads that they allow to expire out of the money, or seemingly dead/valueless debit spreads that are expiring out of the money. 

What I don't think many traders may understand or appreciate is the potential for their "defined risk" trade to turn into an "unlimited risk" trade immediately following expiration. There have been some recent real-life examples that have turned into big losses for traders. 

The problem arises following expiration and requires the stock to make a gap move immediately following the close. If the stock gaps in a manner that drives the spread in the money, the trader may find himself in a position where he can't exercise his long options to cover the short legs of his spread due to notification restrictions on behalf of his broker. Meanwhile, the market maker on the other side of the short options has until 5:30pm to exercise the options.. and if they're in the money, they're going to get exercised. This is a tremendous change in the risk profile of the spread trader's position. See this article by Timothy Collins detailing his TSLA spreads gone wrong on a stock gap-down following expiration for more. 

I'm sure many traders will say "OK, the stock has made a gap move, but now the option I bought is in the money". The problem is that the option didn't close in the money. The option went in the money following the close, so the broker isn't going to auto-exercise it. It has to be manually exercised by the trader who owns the option, and many brokers have options exercise cut off times well before the Options Clearing Council (OCC) cutoff time of 5:30pm. Interactive Brokers has a great FAQ on how options at expiration are handled at their firm. While specific to IBKR, it makes some great points applicable to general options expiration issues.

A recent example of seemingly free money was Gamestop on weekly expiration Friday, January 29, 2021. The stock was trading around $325 at the close, while the $420 call expiring that day was bid at .40, and the $250 put was bid at .30. A trader could have sold that strangle at the close and collected .70; however, they would have owned the tremendous risk of a large stock move for the hour and a half following market close until "last call" for options exercise at the OCC.

Furthermore, the potential also exists that someone could exercise an option that is out of the money. From a financial standpoint, this often makes no sense.. but it's still possible. There's an anecdotal story of this happening with out of the money calls on a biotech heading into a news announcement that came out on the weekend following expiration. See this article by Adam Warner for more.

What does this all mean? It's probably wise to pay a few pennies to close out the short options and take that post expiration-close gap risk off the table. This isn't a situation that will happen often, but if a trader finds himself in this situation it's going to be a rough weekend and a real rough Monday... and it all could have been prevented for a few pennies to buy to close the short legs prior to the market close.  

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