Exiting an Option Position
Exiting an Option Position
When you open an option position you have two choices: Buy it or Sell it. The actual orders used would be “buy to open" or “sell to open". Once you are long or short an option there are a number of things you can do to close the position: 1) Close it with an offsetting trade 2) Let it expire worthless on expiration day or, 3) If you are long an option you can exercise it. If you are short an option you may experience the other side of exercise—being assigned. Let’s look at each of these choices in detail.
Before we begin it is important to note that most stock options traded on all the US exchanges are American-style options. They differ from European-style options in that they can be exercised at any time up until expiration. By contrast, European-style options can be exercised only on the day they expire (although they can still be bought and sold at any time prior to that).
Offsetting the Option
Offsetting is the primary way that most traders close a position. Offsetting is simply a method of reversing your original transaction to exit the trade. You can always sell an option that you previously bought, or buy an option that you previously sold, at any time before the end of the last trading day. The last trading day is usually the first business day prior to the option’s expiration date (the third Friday of the month for stock options).
If you own (bought) a call, you have to “sell to close" exactly the same call (with the same strike price and expiration) to close your position. If you are short (sold) a call, you have to “buy to close" that same exact call to close your position. If you own a put, you have to “sell to close" exactly the same put. And if you sold a put, you have to “buy to close" the put with the same strike price and expiration.
If you do not offset your position, then you have not officially exited the trade. If you are a long a call and you sell another call (with a different strike price or expiration month) you may have reduced your risk, but you have not closed your position. Instead, you would now have two positions (although you may think of it as a single combinational position). Doing an offsetting transaction is usually the best way to close out a position if there is still time remaining before expiration.
Exercising the Option
You can only exercise an option if you are long (own) the option. If it is before the expiration date, you are almost always better off closing it with an offsetting transaction rather than exercising it. When you exercise an option, you give up any extrinsic value it may have. Only the intrinsic value will be realized – any time value remaining is lost.
When you exercise an option you are actually buying or selling the underlying asset. Exercising an option would be appropriate in a situation where there is little or no time value and you want to buy the underlying (in the case of a call) or sell the underlying (in the case of a put). By exercising an option you have purchased, you are choosing to take delivery of (call) or to sell (put) the underlying asset at the option's strike price.
In certain instances, an option may be auto-exercised by the Options Clearing Corporation (OCC). Stock and ETF options with an intrinsic value greater than $0.25 at expiration are subject to auto-exercise, but it is always best to actively manage your option position rather than allowing auto-exercise to occur.
You can get assigned only if you are short the option. You will receive a notice of assignment only if a person that owns the same option exercises it. You have no control over this – it is a decision that has to be made by the other party in the options contract (or when it is auto-exercised on expiration day).
If your short option is in-the-money on expiration day, you are pretty much guaranteed to be assigned. If someone that owns the same option you are short chooses to exercise it early (before expiration day), the OCC (semi-) randomly assigns the exercise to someone that is short the same option. And it is always possible that will be you. However, as mentioned in the previous section, it rarely makes sense to exercise early. So it is unlikely you will be assigned prior to expiration day.
Once you are assigned you must fulfill your obligation under the option contract. In the case of a call option you would have to sell the underlying asset at the strike price to the call holder. In the case of a put option you would have to buy the underlying asset at the strike price from the put holder. How do you meet your obligation in the assignment? It depends on if the option was covered or naked.
If you sold a naked option, you would have to go out into the open market and do the proper trade in the underlying (i.e. buy the stock if you are obligated to sell it. If you already have the correct position in the underlying, you have to do nothing. Your position in both the option and the underlying will be closed out.
If you covered the sold option using another (long) option of the same type and in the same underlying asset (but with a different strike and/or expiration month) you can always exercise it to meet your obligation. However, if the long option is in a farther-out expiration month and has time value left, you are better off closing it with an offsetting transaction and doing a separate transaction in the underlying to meet your obligation.
Letting the Option Expire
The final way you can close an option position is to let it expire worthless. If an option has no value at expiration, and it has not been offset or exercised, the option expires worthless and no further action is required. An option will expire worthless only on expiration day, and only if the option is at- or out-of-the-money (OTM) – that is, the strike price is higher than the underlying price for a call or lower than the underlying price for a put.
Letting your option expire worthless is really the only viable decision when it has no value, which will be the case for virtually all out-of-the-money options at the close of the last day of trading. If you are long an OTM option you will notice that there is usually no Bid price being quoted, since no one wants to buy a worthless option. If you are long (own) an option that expires worthless, you lose all the money you invested in the option.
Of course this outcome is exactly what option sellers are hoping for. If you are short (sold) an option, then you want it to expire worthless because then you get to keep the credit you received from the option premium. You can almost always offset a short option up to the very end of trading – there is almost always an Asked price quoted because lots of people would like to sell you a worthless option.
Before entering any option position, you should understand all the possible ways to close the position. When you are the owner of an option you can close it by doing an offsetting (sell to close) transaction, exercise it, or let it expire worthless. Option sellers can only choose to do an offsetting transaction (buy to close) or let it expire worthless, and there is always the possibility that they may get assigned.