Q&A
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.
A STRONGER CALL POSITION
I’ve noticed many stocks see their strongest or weakest price levels in afterhours or premarket trade immediately following an earnings release. With the stock’s listed options not open during those sessions, it seems an investor with a long call, if the move is up, could be missing out on exiting at more opportune levels. Why is this and do you see any changes in the future?
Whether listed equity options will trade in the afterhours or premarket sessions and afford option strategists the same type of access as stock traders have to their shares is, in the end, a political thing. I haven’t heard of any pending reform to do so.
One real deterrent to extending trading hours for options is liquidity. Remember, calls and puts are derivatives of the underlying, which we can assume will have less liquidity during these trading sessions. Thus, even if you are holding a typically well-traded front month option, closing or adjusting into an attractive spread would likely prove challenging at best.
An argument to extend trading hours for a security’s options might be following an earnings announcement. For the most highly capitalized companies that also sport strong institutional liquidity during the regular trading session, this could make sense. For companies such as Apple (Aapl), Google (Goog), Bank of America (Bac), and the like, we might expect there to be sufficient interest to make a special session worthwhile.
Currently, traders who are long a call (or a put) who find themselves with a quick profit on paper can still take some action in the afterhours or premarket. For instance, with an existing long call, if shares rally to attractive levels and where you might look to sell out the position, the trader can short the stock up to the number of contracts held in order to take partial or lock in profits.
This type of action converts the position from a long call into a synthetic long straddle or a full-fledged long put if 100 shares are shorted for every call held. A couple caveats to using short stock as a hedge against a long call are the trader’s account being approved and being financially capable of holding short stock. In addition, if the stock in question is hard to borrow, this type of hedge wouldn’t be allowed, as your broker won’t be able to locate shares to be shorted.
One way around this possible road block would be to use a synthetic long call made up of long stock and a long put, in lieu of the regular call. Again, the capital requirement for non-risk based accounts will be greater than it would for an equivalent amount of regular long calls because of the cost of the stock. However, if your concern is not being able to trade in the extended hours and when stocks do hit extremes not seen in the regular session, the flexibility to hedge is more readily available.
“YOUR ASSIGNMENT IS COMPLETE”
I thought the process of automatic exercise guaranteed assignment at expiration if the stock crossed a certain price threshold. Recently, I was alarmed to learn that’s not necessarily the case. Is this true? Under what circumstances would I have to be concerned as a trader who focuses on verticals?
Automatic exercise will occur without the contract buyer needing to take any action on expiration if the call (or put) is in-the-money by a penny or more. However, remember that the owner of a contract is not obligated to convert the call or put, regardless of price.
If the trader decides not to take on the obligation of long or short stock via the exercise process, even though the contract has been determined to have expired in-the-money, he or she can put in a “do not exercise” notice with their broker. Similarly, an option that appears to have expired worthless based on the closing price of shares at expiration can always be subject to assignment if a holder of that contract decides to exercise it.
While neither instance is common, news after the official close that affects shares in the afterhours could prompt this kind of surprise. The “surprise” of being assigned may also be the result of the contract holder needing to reduce risk.
As a trader who focuses on verticals, you’re covered to guard against unlimited risk regarding any surprises with your short contract. Since you own an offsetting long call or put, you could opt to exercise or request your own “do not exercise” action.
Under circumstances where you become aware after expiration of a change in the underlying shares that could affect the obligation with your short contract, you can take the same action as the counterparty of your short option. This may wipe out your profits, but at least your open-ended risk would be eliminated.
The good news is scenarios like these aren’t commonplace. However, with the automatic threshold for exercising down to a penny, the surprise of finding oneself with an unwanted long or short stock position that won’t be covered until the next trading session does seem to pose a greater risk. In fact, according to the Options Clearing Corp. (Occ), 20.50% of in-the-money options (which can mean a penny, mind you) went unexercised in 2010. For what typically amounts to a few less pennies profit to close out this type of position prior to expiration, that makes good “sense” to us.
Contributing analysis by senior Optionetics strategist Chris Tyler