Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. |
Tom Gentile of Optionetics |
AUTOEXERCISE EXPLAINED
If I hold a call option into expiration and I do nothing, what happens? Will it expire no matter what, or do I need to tell my broker to sell it?
If you don't close an option position before expiration, two things can happen depending on whether the option contract is in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). Remember, an OTM call option is one where the strike price is higher than the stock (index, exchange traded fund [ETF], or futures) price. An OTM put has a strike price below the current stock price. An ATM option has a strike price equal to the stock price.
OTM and ATM options expire worthless. They have no embedded value and there is no incentive for the holder to exercise that option. If I hold an XYZ call option with 50 strike price and XYZ is trading at $49 a share, why would I exercise an option to buy XYZ for $50 when I can pick it up in the market for $49 a share? On the other hand, if the stock is trading for $51 and I hold the XYZ 50 put option, there is no reason for me to exercise that put and sell shares for $50 when the market will buy it for $51. There are instances when slightly OTM options are exercised by the holder, but in most cases OTM and ATM options will expire worthless because they have no real or embedded value.
In-the-money options, on the other hand, have value and, if the strategist forgets to exercise that option, they are in danger of leaving money on the table. For that reason, the Options Clearing Corp. (OCC) has an autoexercise rule to protect investors in these situations. In fact, the rule was recently amended. Beginning with the June 2008 options expiration (June 21, 2008), the threshold for automatic exercise was lowered from a nickel to a penny a contract. Therefore, any option that is ITM by one cent or more at expiration will be automatically exercised. If the strategist doesn't want that option exercised, they should send their broker the instructions in the week prior to option expiration.
BUTTERFLY OR IRON BUTTERFLY?
What's the difference between a butterfly and iron butterfly?
The iron butterfly is a variation of a butterfly spread. In the traditional butterfly, the strategist creates the trade using all call options or all put options. For example, with XYZ trading near $50 a share, the strategist might create a butterfly by selling two ATM calls (calls with a strike price of 50) and buying a higher strike call (55, for example) and a lower strike call (45). Therefore, the butterfly includes one ITM option, two at-the-money options, and one OTM option. The same trade can be created with put options. Whether using puts or calls, the two short options form the body and the long options create the wings of the butterfly.
When creating a butterfly, the goal is for the stock to stay in a range and for the ATM options to lose value over time. The profit comes from the fact that if the stock price moves toward the strike price of the ATM options, the short options will lose more value than the other two options combined. As expiration approaches, the position can be closed out when the short options have little or no value, which involves buying back the "body" and selling the "wings." The ITM option should retain most of its value and the OTM option, which is really a hedge, will expire worthless.
While the butterfly spread uses only puts or only calls, the iron butterfly uses both puts and calls. It can be considered a combination of a bear call spread and a bull put spread -- that is, the strategist sells a call and buys a call with a higher strike price and also sells a put and buys a put with a lower strike price. The short call and short put have the same strike price and form the body. Both long options are OTM and create the wings. Ideally, the stock will close at the strike price of the short options and all of the options expire worthless.
Now, you may ask, which is better? Brokerage commissions are a factor to consider because the iron version includes four legs (short call, long call, short put, long put), while the butterfly spread includes only three (a long call [or put], two short calls [or puts], and another long call [or put]). In addition, since the butterfly spread involves the purchase of an ITM option, it is created for debit -- that is, the cost of the long options will be greater than the premium received from the short options. However, the iron butterfly produces a credit because the premium received from selling the short options will be greater than the cost of the long options.
Finally, since the wings of the iron butterfly consist of two OTM options, while the butterfly uses one ITM and one OTM, the iron butterfly will require less capital (although margin requirements will vary by brokerage firm). Outside of that, the risk/reward of the two trades will yield similar results.
Originally published in the August 2008 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2008, Technical Analysis, Inc.
August 2008 Contents