Expiration is the moment of truth for many investors who hold or are short options that are about to expire. Some contracts will end up in-the-money, some out-of-the-money, and a very rare few will end with underlying closing prices that are right at-the-money and/or strike price. In the old days we only had a regular expiration that took place on the third Friday of every month. Today we not only have regular expiration but also weekly options cycles. Weekly options are listed each Thursday in certain options classes and expire 8 days later. So, these days almost every week is an expiration week of some kind!

Some options, such as Index options, expire the morning of the Friday and are cash-settled. Cash-settled means that if the option closes in-the-money the settlement is paid out in the form of cash to the long option holder. This differs from non-index stock settled options where the delivery is in the underlying stock. We will refer mainly to stock-settled options in this edition to keep things simple.

Effectively, during expiration week time is beginning to run out for the option contracts in question. Any remaining time value begins to decline at a rapid rate. Options that are near the strike have the most time value and can be more volatile as they face a binary outcome. Options that are far out-of-the-money are much slower to react to stock movement as they sit more distant from their strike prices. Options that are well in-the-money are starting to react more in lock-step to their respective underlying stocks as their delta pushes towards 1. Delta refers to the reactiveness of options to underlying stock movement. Options that are near the strike have the most time value and can be more volatile as they face a binary outcome - they will either be worth something or nothing in a few days.

It is said that expiration weeks tend to be more volatile than others, but I think that depends on too many outside factors – dealer option positioning, open interest size, and more recent market movement. When clients, whether retail or institutional, are buying and selling calls and puts, much of the time the counterparty will be a market maker. Market makers will generally hedge out their trade risk (called a delta hedge) by buying and selling stock. Their desire here is to neutralize the risk in the overall position as much as possible. Now, we could spend a whole edition talking about this process, but for now I think the most important point is that participants actively trading and hedging are often offsetting one another. As a stock surges through a strike on the Friday of expiration, the long call holder will often need to sell stock, while the short call holder will need to buy stock.

Now, let’s get more specific and give an example of how our featured trade, the covered call strategy, works on expiration. If the client has sold covered calls and the stock looks like it will close above the strike price, decisions will have to be made. When a call is in-the-money, the call owner will exercise the call, thereby forcing the covered call strategy to deliver the underlying stock shares. If we, as the call seller, are okay with selling the stock, we don’t need to do anything. When the stock is called away (auto-delivered to call owners), the option position expires, and we are left with no position whatsoever come the following business day.

Importantly, however, we must recognize any tax implications that may trigger in the event of a stock disposition/sale. If this is an equity position with a lower costbase that we have held for some time, we need to be ready to react appropriately and in line with our goals as expiry approaches. Should we not wish to sell our stock, we need to do one of two things: 1) close the position by buying the calls back, or 2) roll the in-the-money call position to another expiration and strike. When we close the position, we need to make sure we have funds on hand in order to finance the buyback of the call. We will need to pay the prevailing intrinsic value for the call, any remaining time value (and possibly an additional small premium to make it worth the market maker’s while). For example, we may have sold a call one month ago for $1 which is now valued at $3. This buyback amount could come from a cash position, or it could require a disposition of only a portion of the underlying stock position. Selling only some of the equity position in order to fund the call buyback results in only a small disposition versus the larger outcome of being called away on the entire in-the-money position.

So, as you can see, some crucial position management is required as we enter expiration week and consider the possible closing prices for our stock as the week goes on. This is often a chance for traders and investors to manage the risk in some of their positions. It may even be prudent to not only close positions that are in-the-money but also some that may be out-of-the-money. For example, if we sold a covered call for $1 that is now trading at $0.10, we might opt to buy it back. Why? Well, we have harvested 90% of the premium, and even though the calls may remain far out-of-the-money we know that stocks can occasionally move unexpectedly and aggressively. Recall that the short call still represents a capping of upside to the underlying stock that we hold – for a mere $0.10, we can remove this ongoing “risk”. In fact, there is no rule that we should only roll or cover a position during the expiry week. If a covered call position has realized the majority of its capture within the first week or two of the options cycle, we can opt to roll the position into a new month and strike to take advantage of additional premium or theta erosion. Keep in mind that this may involve rolling to a lower strike, so make sure that this new call-away level fits with your goals for the underlying holding.

In conclusion, expiration weeks are more often than not quite busy due to the rebalancing and squaring off of many types of open derivatives positions. If you're involved, you’ll want to keep positions on your screens for careful monitoring not only throughout the month, but even more so during expiration week.

IMPORTANT DISCLOSURE INFORMATION

The use of options transactions as an investment strategy can involve a high level of inherent risk. The information in this presentation, including examples using actual securities and price data, is strictly for illustrative and educational purposes only and is not to be construed as an endorsement, recommendation. Any screenshots, charts, or company trading symbols mentioned, are provided for illustrative purposes only and should not be considered an offer to sell, a solicitation of an offer to buy, or a recommendation for the security. Investing involves risk, including risk of loss. Please Note: Certain options-related strategies (i.e. straddles, short positions, etc.), may, in and of themselves, produce principal volatility and/or risk. Thus, a client must be willing to accept these enhanced volatility and principal risks associated with such strategies. In light of these enhanced risks, client may direct Registrant, in writing, not to employ any or all such strategies for his/her/their/its accounts. Please Also Note: There can be no guarantee that an options strategy will achieve its objective or prove successful. No client is under any obligation to enter into any option transactions. However, if the client does so, he/she must be prepared to accept the potential for unintended or undesired consequences (i.e., losing ownership of the security, incurring capital gains taxes).

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