Monday, May 18, 2009

MythBusters- Cheaper to let Options Expire?

The fourth installment to our Options Myths series will cover:

Myth #4: It's cheaper to let options expire!

Not really sure how pervasive this myth is, but I'm sure a few people have been duped into letting an option expire and realizing it's NOT always cheaper. So, let's jump in.

The first problem with making blanket statements about options, such as myth #4, is there are so many different types of strategies and scenarios that it's darn near impossible to state that one technique is better ALL the time. Are there scenarios where allowing an option to expire is cheaper? Sure, but there are many more scenarios where allowing an option to expire is much more expensive.

Expiration Recap:
At expiration an option is either Out-of-The-Money or In-The-Money. All OTM options expire worthless and all ITM options are automatically exercised. As an option trader, there are only 4 different scenarios that may play out with your option positions at expiration:
-Long OTM option
-Long ITM option
- Short ITM option
- Short OTM option

Long OTM options:
If you're long an OTM call or put option that remains OTM, riding to expiration will merely lose you more money as the option value will continue to erode until it expires worthless at expiration.

Long ITM options:
What if I'm long an ITM call or put? Will riding to expiration and letting the option expire be cheaper than exiting prior to expiration?
The answer is no! As stated, ITM options are automatically exercised, thus riding an ITM call (put) to expiration will result in you having to buy (sell) 100 shares of the underlying stock. Coming up with capital to buy (short) shares is obviously much more expensive than merely selling the option before expiry.

Short ITM options:
Suppose I'm short an ITM call or put. Would riding to expiration be cheaper than closing them out prior to expiration? The answer is NO!
Short ITM Calls would automatically be assigned, resulting in me having to SELL 100 shares of stock at the strike price. The margin required to short 100 shares is going to be greater than whatever it costs to close out a short call prior to expiration.
On the other hand, allowing a short put option to expire ITM will result in having to buy 100 shares at the strike price. The capital outlay required for that is obviously going to exceed the minimal cash required to close the trade.

In the case of a covered call (long 100 shares & short ITM call), you may want to ride to expiration and allow assignment, but it's not necessarily cheaper than closing prior to expiration as the myth purports.

Short OTM options:
And that brings us to the 4th and final scenario- riding short OTM options to expiration. This is the most common scenario where it is cheaper to ride an option to expiration. For example, suppose I'm short a naked OTM put option with a week to expiration that is worth $.05. Consider the following 2 scenarios:

Close now
Buy to Close put for $.05
Pay Commission

Ride to expiration and watch expire worthless
Save $.05
No Commission

Although it would be cheaper to ride to expiration, that assumes the option remains OTM. What if the stock undergoes a gigantic move the last few days before expiration, resulting in your short option moving ITM by a dollar? That option which was trading at $.05, is now trading at $1.00. In retrospect you will kick yourself for not buying it back at $.05 when you had the chance. That's the risk you run with trying to eke out every last penny of a short option's premium. My experience has taught me to buyback any short options that are almost worthless (maybe $.15 or less). Might not be a bad idea for you to at least consider the benefits of foregoing the last few dollars in exchange for eliminating risk.



Tim said...

This article is really nice as it helped me to clear so many wrong assumptions that I have made. So many good points about trading options is explained with relevant example. Thank you so much.
trade options


Theirs always a myth floating out their.