Options trading is a method used by traders to attempt to buy investments at an optimal price. An option can be exercised or not, depending on the option holder. Two desirable options to consider are the put option (the right to sell at a certain price) and the call option (the right to buy at a certain price).
When the buyer can exercise the option
“Out of the money” (OTM) refers to the situation where an investor buys a call or put option on an investment. When buying the option, the strike price is set at which the asset is sold or bought, regardless of the closing price.
When the strike price is higher than the market price, the call option is referred to as “out of the money” (i.e., the buyer will pay more than the value of the asset in the market). Similarly, a put option will be out of the money when the strike price is less than the current market price.
Examples of exercising an out of the money option
Suppose a trader has a short position in 2000 shares of a certain stock (XYZ) and owns 20 XYZ 50 options expiring (selling at $50 to mitigate risk) as protection. They want to cover the short position before expiration (in case the price drops) and enters a bid of $49.98 for all 2000 shares.
Now, suppose what happens when the stock closes at $49.99 on Friday. The option is out of the money by one cent (since the selling price was decreasing) and the market maker (MM) did not get the price they wanted for the stock.
However, due to the buyer’s protection from a significant loss (20 XYZ 50 options) expiring, the risk of maintaining a short position in the stock is not what the market maker prefers. Therefore, the buyer exercises the options. Instead of paying $49.98, the market maker has to pay $49.99 (the strike price of the options). This is acceptable for this trader and better than taking risks over the weekend.
Weekend risk exposure
“Weekend risk exposure” means not exercising options at market close on Friday. Imagine that news of the short selling comes out on Friday after the market closes. The opening price of the stock on Monday is likely to be lower than Friday’s closing price, increasing losses for the market maker if they did not exercise their options on Friday.
The price will be lower, as demand will decrease over the weekend. Owners of the few out of the money call and put options (investors who bought options to buy or sell at certain prices) who are aware of the upcoming short selling before the option cutoff time (around 4:30 PM Eastern Time) begin to take action.
Owners of the few out of the money call options are required to inform their brokers not to exercise those options. Owners of the few in the money put options (who bought options to sell at certain prices) are also required to inform their brokers not to exercise them.
Note: None of these actions are executed automatically. To exercise an out of the money option or to allow an in the money option to expire, you must inform your broker before the cutoff time.
Final thoughts
This worst-case scenario does not happen often. It is intended to help you understand exercising out of the money options and their impact and how to mitigate the risks of call and put options.
Frequently Asked Questions
How do you profit from out of the money put options?
Put options that expire out of the money will be worthless, but out of the money put options can create profitable trades if the price of the underlying stock declines. If this happens, and the price of the out of the money put option increases, you can sell those options for a profit before they expire, even though they are not in the money. The delta factor of the option is useful for this type of trading, as it measures how sensitive the option is to changes in the value of the underlying stock.
How
Do you buy put options?
You typically need to request additional permissions from your broker to trade options. Once you successfully apply for an upgrade to your brokerage account, you can simply place a buy order as you would with any other stock. You should keep in mind that options contracts do not trade at the same size as the underlying stocks, and insufficient trading can affect the prices you get in market orders.
Was this page helpful?
Thank you for your feedback! Please let us know your reason for another opinion.
Sources:
Fidelity. “The Power of Delta.”
Source: https://www.thebalancemoney.com/can-an-otm-option-be-exercised-2536809
Leave a Reply