Do Most Options Expire Worthless?
The truth is that neither of these beliefs is entirely accurate. The first person’s statement implies that selling naked options – as an alternative to selling covered options – is a wise strategy. However, this is also fraught with risk. The second person’s statement is also incorrect, but it contains a real point. More traders believe that it’s better to sell options rather than buy them. However, attention must be paid to risk management. Generally, selling covered options is the right strategy for most investors, even though it may not be very valuable for short-term traders.
Writing Covered Options and Option Expiration
Most beginner traders love to write covered options when the option expires worthless. The truth is that this often results in a satisfying outcome. Traders still own the stock, have the option premium in the bank, and it’s time to write a new option and collect another premium.
However, this thinking is shortsighted. Certainly, when traders buy a stock for $49 and write options with a $50 strike price, and the options expire with the stock price at $49, the strategy works out about as expected, and traders congratulate themselves.
There are two scenarios in which traders who achieved this desired outcome (options expiring worthless) might have made a serious mistake while waiting for the options to expire – a mistake that cost them money. Let’s take a look at these rare situations.
Case #1: Sharp Decline in Stock Price
A person may feel satisfied writing a $200 option and seeing it expire worthless. However, if that happens when the underlying stock price drops below their purchase price (for example, falling from $49 to $41), they won’t feel quite so satisfied. Of course, your losses are reduced because you sold the option, but depending on how much the stock price has dropped, the premium received may not be sufficient to cover the significant loss.
What will you do now? If you refuse to accept the reality of the stock price at $41 and want to sell options with the same $50 strike price, there are two potential problems. First, the $50 option may not be available anymore. Second, if it is available, the premium will be very low.
This scenario raises a new question: Will you write a new type of option? Would you want to write options at $45, for example, even though if you are lucky enough to see the stock price rise that much, the result would be a guaranteed loss?
The point is that the future becomes uncertain, and knowing how to proceed requires some investment experience. The correct technique would be to manage the position’s risk once the stock price drops below the pre-chosen threshold.
Case #2: High Implied Volatility But Declines by Expiration Date
Traders love to write options when implied volatility (IV) is significantly higher than its historical levels, as they can collect a higher-than-usual premium when writing covered call options. The allure of options premiums can be so enticing that some traders ignore the risk and trade an inappropriate number of option contracts (creating issues related to position size). The premium on the option can change as implied volatility fluctuates.
Let’s consider this scenario. You hold a covered call position, having sold a call option at a $50 strike price on a stock currently trading at $49, when a disruption occurs in the stock market. This can result from a major political event, such as a presidential election or Brexit developments.
In
Under normal market conditions, you would be very happy to collect $150 to $170 when writing a covered call for one month. However, in this hypothetical scenario, with only three days left before your option expires, the option you sold is priced at $1.00. This price is very high (it is usually priced around $0.15), so you refuse to pay this amount and decide to wait for the option to expire.
What will the experienced trader do?
The experienced trader does not care about the price of those options in a vacuum. Instead, this more advanced trader also looks at the price of the option that expires in one month. In this improved environment of implied stability, they notice that the option that expires later is trading at $3.25. So what does the savvy trader do? They enter a spread order to sell the option, collecting the difference of $2.25 per share.
The trade involves buying the short-term option (with an unattractive yield of $1.00) and selling the next month’s option (with an attractive yield of $3.25). The net cash credit for the trade is $225. This cash is the credit you hope to keep when the new option expires worthless. It should be noted that this is much higher than the normal income of $150 to $170 per month. Of course, you may have to pay a “bad” price to cover the option that was previously sold, but the only number that matters is the net cash collected when rolling the position to the next month – that is your potential new profit for the coming month.
Frequently Asked Questions (FAQs)
What happens when a covered call expires in the money?
If the stocks reach the strike price of the option, it is likely that the option will be executed. The option is unlikely to truly expire, although that technically depends on the person who holds the option. You can expect someone to buy the shares that cover the option, even if the option is just $0.01 above the strike price. The brokerage will close the option trade and remove the option from your account. The shares you owned to cover the option will be sold at the strike price, minus any trading costs. This process may not update in your account immediately, but it should be updated at the beginning of the next trading day.
What happens when the option expires worthless?
When the option you own expires without reaching the strike price, your brokerage will automatically close the position and remove the option from your open positions. You do not need to do anything for this to happen. If you would like more details, you can view trade confirmations and account history.
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Source: https://www.thebalancemoney.com/options-expire-worthless-4056646
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