Most of the strategies we discuss in Know Your Options are based on the presupposition that we will either close the trade before the options expire, or that all the legs of our position expire either in-the-money or out-of-the-money.

The Options Clearing Corporation automatically exercises any equity options that are at least one cent in-the-money as determined by the closing price of the underlying on the stock’s primary exchange on expiration day.

Traders with a long position can submit instructions through their broker dealer to exercise an option that’s technically not in the money or not to exercise an option that is in the money. This is known as “contrary exercise” or “exercise by exception” and means that if you have expiring short options with a strike that’s close to the stocks closing price, you need to be prepared for multiple scenarios.

Why would someone choose not to exercise an option that’s in-the-money?

Here’s are two examples:

You own a 50 delta put with a strike of 100 that expires in two days. Some bad news about the stock hits the tape and sends the shares tumbling all to way to $90. Instead of selling the put, you (wisely) choose to buy 100 shares of stock for $90, locking in $10 in profit and also preserving the optionality of your position. No matter what happens, you’ll make at least $10 at expiration (minus whatever you originally paid for the put) and if the stock rallies back above $100/share, you might even end up making more.

Let’s say that does happen. On expiration day, the shares recover and trade all the was up to $105/share. You’re long the 100 shares you bought and also the put that gives you the right to sell them at $100 each. But you’d be foolish to sell something at $100 that you could instead sell for $105. So you do exactly that – sell your 100 shares for $105.

It was a great sale because the stock reverses the up move to close at $99.80.

Your astute trading moves earned you $1,500 in additional profits even though the stock ended up very close to your long strike, but now you probably don’t want to exercise that put that looks like it’s in the money. (Even if you could buy 100 shares in the post-market trading session, it’s probably not worth the hassle to try to get an extra 20 bucks. Depending on the fees you pay for exercise and/or assignment, it might even be a losing proposition.) So you tell your broker not to exercise your put.

You have no position and $1,500 in cash. But someone who was short that same put is in for a surprise. That trader might have made sure that the shares he buys and sells as a result of options expiration sum to zero, leaving him with a delta-neutral position on the Monday following expiration. Instead, because you declined to exercise your put, he ends up short 100 shares instead – with the unlimited upside risk that entails.

Example #2:

You own the same $100 put and nothing happens. The official closing price of the stock on expiration day is $100.50 and your put is out of the money. Because you’re a dedicated trader however, you’re still sitting at your desk at 4:30 Eastern time when that negative news story hits the tape. In the after-market session, shares of the stock tank, hitting $85. Recognizing that you still have an hour to exercise that 100 strike put, you snap up 100 shares at the depressed price. Then you submit instructions to your broker to exercise your put, locking in that same $1,500 in profit.

Despite your good fortune in locking in a profit, over the weekend it becomes apparent that the company is in deep trouble and shares continue to fall, opening for trading on Monday at just $75. Someone who was short that put – and who turned off his monitors at 4:01 and hustled out for a few happy hour beers with friends – now finds himself with a loss of $2,500 (and counting.) Those were expensive beers!

The Takeaway?

It doesn’t necessarily take a news item to spur big moves like these. The crowded “Reddit meme” trades like GameStop (GME Quick QuoteGME - Free Report) have been adding huge volatility to a handful of stocks, especially around options expiration.

If you have open long or short options positions that are expiring, you’re not done when the bell rings on Friday. If you have long positions, you might find opportunities to mine extra profits. If you’re short, you can make an informed decision about whether someone who is long might choose to make a decision that’s different from the automatic-exercise rules.

If you think you may be at risk of buying or selling shares (or not buying or selling shares you were expecting to), you have an opportunity to mitigate the risk.

Personally, if I was the short in either of the above examples but was uncertain about what was going to happen, I’d cover half of the stock position.

Or better yet, understand these examples as a powerful reason why you should spend a nickel or a dime to cover your shorts at expiration even if you think they’re about to be worthless. It’s cheap peace-of-mind - and you probably already have a profit in the trade if you can buy them back for 10 cents.

If you don’t have any long options to babysit, you can be the one shutting off the monitors and heading out for a beer. With the money you have in your pocket, maybe you’ll even pick up the tab…

-Dave

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.

Interested in strategies with profit potential even in declining markets? Maybe our Short List Trader service is for you.