Many of you have questions around options expiration
and how a trade might end.
So in this video, we'll discuss what rights and obligations
of options, being in and out of the money,
how to avoid assignment, and a few risks
you should be aware of.
Hello, my name is John McNichol, and this is Comment Below.
OK, so what are expiration dates?
The expiration is when the option stops trading.
This is typically going to be the third Friday
of each month for standardized option contracts.
However, there are other contracts
called weekly options, that may expire each and every Friday.
Now what happens to this option position
depends on if one is long or short the option
and if that option is in the money or out of the money.
The buyer of the option has the right, but not the obligation
to buy or sell a stock at a certain price
within a certain time-- the expiration.
They can do this at any time up through that expiration.
The seller has the obligation to buy or sell
a stock at a particular price on demand up through expiration.
So let's talk about what it means
for an option to be in the money or out of the money.
Now when we look at calls, if the stock
price is above the strike, that option would be in the money.
Whereas if the stock price is below this strike,
that option would be out of the money.
Now when we look at puts, it's basically flipped over.
When the stock price is below the strike,
that option would be in the money.
And then when the stock price is above the strike,
that option would be out of the money.
When an option is in the money, that's
what we need to discuss assignment and exercise.
For the seller, an in the money option may be assigned.
That means the seller of a call would actually
have to sell stock.
In the case of a put, would actually
have to buy stock upon assignment.
Now in the case of the buyer of the option,
if they don't close out that position prior to expiration,
that in the money option may be automatically exercised,
where it's assumed that the buyer of the option
actually wants to take a stock position in the case of a call,
or in the case of a put, may actually
want to take on a short stock position.
Let's take an example of a long call.
Let's say the buyer the option has a strike price of $50
and the stock price is at 52.
That option would be in the money.
Now the buyer of that option has a few things they can do.
They may choose to sell to close the option, hopefully
at a profit.
They may allow the option to go to expiration, in which case,
if it's still in the money, that option may
be automatically exercised.
Now the buyer of that option must have enough funds
in the account to fulfill that exercise.
In the case of a $50 strike, that
would be $5,000 per contract, since each contract represents
100 shares.
There may also be brokerage charges for that exercise,
as well.
Now let's look at an example of a short put.
Now this is an obligation for the seller of that option.
They took on an obligation to buy the stock at $50.
If the stock price is at 48, that option
is also in the money.
They're obligated to buy that stock at $50.
They may choose to buy to close that option
for a potential loss before expiration, thus
removing the obligation to buy that stock.
If they allow it to go to expiration
and it's still in the money, they'll
be assigned those shares at $50.
Once again, they would have to put up $50 per share,
in this case, $5,000 per contract,
and they would own those shares, and it
would be at potentially a resulting loss.
Now keep in mind when they're assigned those shares,
prices can change the following week that
may result in a gain or a loss.
Let's talk about more complex strategies.
For instance, a vertical spread.
That's what one buys and sells an option
of the same expiration with different strikes.
Those different strikes enable one to define the gain
as well as define the risk in that trade.
This removes the potential risk of having
a make a contract, where one is obligated to buy or sell
shares.
The long option helps offset part of that obligation.
Let's look at a short put vertical as an example.
What we'll do here is we'll sell one put at a $50 strike
and buy a cheaper option at the 47.5 strike.
So let's talk about some potential outcomes
for this strategy.
Let's say price trades through both options and ends up at 47.
Both of those strikes the 50, and the 47.5
would be in the money.
The short strike of 50 would be obligated
to take possession of those shares at 50,
but have a long option that gives us the right
to sell the stock at 47.5, thus defining
the risk in that trade.
So in this instance, we would have a maximum loss,
but we do not have to own the shares.
So now what if the price goes to 48.
That means the price would actually
fall in between the spread.
Now the option that we sold would be in the money,
thus creating an obligation to buy the stock at $50.
Now since the 47.5 and a half strike is out of the money,
no action would be taken.
Now this example, we would be obligated
to own the stock at $50, which means
one would have to have the funds to take that stock position.
Let's talk about the third outcome, both options
being out of the money.
This would be a desired outcome, as if the price is
above both strikes, both of those options
would expire worthless, and thus, the short seller
would actually collect the full premium that they sold.
A few things you should know.
Let's talk about pin risk.
That's what a stock price is right at the short strike.
In our vertical example, that would be at the $50 level.
Now one may or may not be assigned.
Go ahead and check out this video on pin risk
to learn more.
Now if one is assigned, and you don't
have the funds in the account, you will actually be on margin
and would actually pay interest.
If you don't have enough funds, one
May be forced to close out that position
as soon as it's been assigned.
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