Today brings a great opportunity to examine the difference between the theories of options pricing and the mechanics of actually trading.

The issue is “contrary” exercise.

I got this email from a reader:

Dave,

“Barring a major mistake, only options that are in the money are exercised. No rational party would ever choose to buy stock above the current market price or sell it lower.” Your quote.

Last Friday DEC 18^th I was short 10 WFC 29.5 Calls. The stock closed at 29.01 on Friday. That night someone exercised the 29.5C on me since Wells announced after trading 3PM CDT that it was selling its student loan portfolio. Fortunately I owned the stock. However the stock opened near $30 on Monday morning and had they not exercised I could have sold the stock .50 higher than they took it from me. So lesson learned. There are times out of the money will be exercised.

Respectfully,

D.M.

Here was my reply:

Thanks for writing. I can definitely clarify the issue.

When I said that no rational party would exercise an out-of-the-money option, I meant it from a theoretical standpoint, but I should probably have better explained what "in-the-money" technically means, especially right at expiration.

The Options Clearing Corporation automatically assumes that the owners of options want to exercise them if they are at least 1 cent in-the-money. They base that calculation on the official closing price posted by the underlying security's primary exchange. If you're long an option, as long as you don't make a different choice, this is what you can expect to happen.

Because the closing price isn't established until a few minutes after the close of trading - and to give traders some time to assess their positions and contact their brokerage firms to make their wishes known, the OCC allows clearing members to notify them until 5:30 Eastern time on expiration Friday if they want to exercise an option that's out-of-the-money based on the closing price - or to decline to exercise an option that's in-the-money. 

Trading firms establish their own (earlier) time limits on the submission of so-called "contrary" exercise instructions for customers who own options. Check with your account rep to make sure you have enough time to do what you want. (More on this later...)

When there's a significant news item after the underlying closing price has been established by the primary exchange, traders can still choose to submit contrary exercise instructions for over an hour after the close of trading. Generally, companies avoid making major news releases on the day that options expire to avoid the associated price volatility, but there's no rule to prohibit them from doing so.

In this case, it's likely that those Wells Fargo (WFC Quick QuoteWFC - Free Report) shares were already trading higher in the after-hours market when someone made the decision to exercise them - even though the strike was higher than the official closing price. If so, it was a no-brainer for them. They were still holding to right to buy the stock for $29.50/share. If they could simultaneously sell it at a higher price, of course they would want to do it. 

49 cents is a fairly big contrary exercise, historically speaking. It's pretty rare to get assigned on an option that appears to be that much out of the money. If it looks like the stock is going to close within a few cents of a short strike, I'd usually recommend buying back the options late in the day on Friday. If they're offered at 5 or 10 cents, it's cheap insurance against contrary exercise - especially since you're probably already sitting on a profitable trade. 

Unless you have a reason to think there might be news after the close, I don't think it's worth it to waste money - even if it's only a penny - when the stock is 49 cents away. A long as your potential losses aren't unlimited, my guess is that you'll end up ahead in the long term by letting those options expire worthless most of the time and absorbing the loss of opportunity cost once in a while.

-D

Going on Offense?

Is there some way you can make the contrary exercise process work in your favor? Absolutely.

Being assigned on options you sold can be an uncomfortable experience, but any time you sell an option you have to be prepared for that possibility. Therefore, those who are short should probably be prepared to watch the stock for a couple hours after expiration – but traders who are long options should do the same thing. There might be opportunity there.

Here’s a trade I did on purpose in Tesla (TSLA) on Friday. You’ll recall that some extreme price volatility was possible around the close because of the pending inclusion into the S&P 500 and a potential order imbalance.

(I wouldn’t recommend this during normal expirations, it’s likely to be a waste of money. Spoiler alert: it didn’t work. I wasted money on it, too – but I feel like it at least had a chance in these unusual circumstances.)

When the stock was trading around $675, I bought 100 far out-of-the-money 900 strike calls for a penny each. My total expenditure $100, plus commissions. Normally, that would be like flushing 100 bucks down the toilet, but because I thought there could be some aberrant price activity around the close (and/or in the after-market session) I gave it a shot.

Then I layered 10,000 shares worth of sell orders at prices between $900 and $950/share. If there was a weird print and I got filled and sold shares over $900, I could use the contrary exercise procedure to buy those shares back cheaper, locking in instant profits.

But...later in the day, I cancelled all those sell orders.

(It didn’t matter anyway. The shares closed at $695 and then traded lower in the after-market. $900 turned out to be a pipe dream.)

Why did I cancel them? Because I placed a call to my account rep at my brokerage firm to inquire about the deadline for contrary exercise and I got his voice mail. I left a message, hung up, called the main customer service number and then spent 40 minutes on hold before a person picked up. He informed me that I had until 5pm Eastern to guarantee the instructions were executed and until 5:15 to submit them on a “best effort” basis – meaning they would try, but with no guarantee.

With that kind of wait time, I didn’t feel comfortable potentially being short 10,000 shares - of the hottest stock ever, on the weirdest day ever – when it became clear that communicating my intention to exercise my calls wasn’t a sure thing.

My point in telling this story is twofold.

First, if you understand the mechanics of the markets you’re trading, you can sometimes use the rules to maximize profit opportunities.

Second – and more importantly – if you’re going to take a wild swing at a trade like that, please be sure you’re positive about every aspect of how the trade will work and limit your risk as much as possible. Any time there appears to be an opportunity for long-shot profits, there might be more risk than a strict theoretical understanding of options might suggest.

Be careful.

Have a healthy and happy holiday!

-Dave

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