Stan Freifeld

Make Great Expiration Day Trades

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Keeping Your Cash, Part 2: Put Options

How does this work for long puts? Almost the same way, except in this case, instead of selling the stock, you would have to buy it. (Remember, calls give you the right to buy stock at the option's strike price, but puts give you the right to sell shares at the strike price.)

For example, with XYZ trading at $49, the XYZ Nov 60 Put might be bid at $10.70, and offered at $11.30. If you closed out the position by hitting the bid, you would only get $10.70 for your put that is really worth $11.

So, buy the stock at $49 and exercise the put. If you work through the numbers, you'll see that you're effectively getting the full $11 for your put.

You should note that in either the long put or call situation, you will have to pay commissions to buy or sell the stock. Even so, with commissions being as low as they are today, saving even 5 cents on a four- or five-contract position makes sense.

Margin and Automatic Exercise

If you're thinking that there may be margin problems in either the put or call scenario, you probably can stop worrying. There is something called an "irrevocable exercise notice." This is what allows you to be able to buy or sell the stock without putting up any margin, because you are in effect guaranteeing that you will close the position (via exercise of the option) the same day.

Many brokers will see that your in-the-money option will be exercised and you won't actually have to tell them that you are making this irrevocable election. However, if they ask, that's what you tell them. If they ask, and then don't know what you're talking about (I've heard stories like that), you may want to find a broker who does. (Get 5 Tips for Moving Your Brokerage Account.)

Naked Short Options

What about naked short options -- how do you close them out at expiration without taking a beating? The concept is again similar, except in this case, you don't have control of the situation. Remember, you may be assigned on a short option, but it's not 100% guaranteed.

The probability of this happening is remote, but because it is possible, your broker will probably require margin for a stock trade done in anticipation of assignment. So if your account has the available margin, then you can close out the naked position by buying stock for calls, and selling (shorting) stock for puts.

If you don't have the margin available, you might have to bite the bullet and buy the options back from the market maker. It will be instructive for you to think through the process.

Even with the automatic exercise rules providing that options that are in the money by even one penny will be exercised (and that you will therefore be assigned), the holder of a long option position that is only slightly in-the-money may request not to have his or her options exercised.

Market Makers and Pin Risk

It's interesting to note that the actions of the market makers, as described above, account for a phenomenon that occurs quite frequently. That's when a stock closing on expiration Friday is trading very close to a strike price. In fact, some would say that the stock is being dragged to the strike price.

Assume a stock is trading near a strike that has a large open interest in both the puts and the calls, and it's otherwise a relatively quiet day for both the company and the shares. Assume XYZ is trading around $51 and there is a large amount of open interest on both the puts and the calls at the $50 strike.

Since the calls are in-the-money, the market maker will be bidding just below parity. The typical public trader will hit the bid to close out his position. When the market maker buys the calls, he then sells the stock. Since the open interest is large, when enough calls are bought, there will be a lot of downward pressure on the stock -- moving it lower and lower.

Eventually it will fall under $50, and now the XYZ 50 Puts are in-the-money. So, now the market makers will bid just below parity for the puts. When the market maker buys the puts, he then has to buy stock, thus exerting upside pressure. And so it goes like a seesaw, the stock will teeter around the strike price right through the close of trading.

Does this happen all the time? Obviously not. There are lots of other forces acting on the stock, and in the example above, if XYZ was trading at $67, then regardless of the size of the open interest on the $50 strike, you would not expect the stock to be pushed down to $50.

However, when the conditions are right, there is a high probability of the stock trading very close to the strike. It is this condition that leads to some very profitable trading on expiration day.