Knowing an Out-of-the-Money Option and How to Protect Against It
Options trading is a method used by traders to buy investments at the best price possible. An option gives the owner the choice to either use it or not. There are two options: a put (giving the right to sell at a specific price) and a call (giving the right to buy at a specific price).
When someone buys a call or puts an option on an investment, and the price specified in the option is different from the actual market price, it's termed as "out of the money" (OTM). For instance, if a call option's price is higher than the market value of the asset, it's considered OTM. Similarly, an OTM put option has a price lower than the current market value.
"Exercise" means taking action on an option you own, allowing you to buy or sell at an agreed price.
Out-of-the-money (OTM) options often end up worthless. Yet, sometimes, an owner of an OTM call may decide to exercise it, although this is rare. When an option is OTM upon expiration, the investor faces a complete loss of their buying price, letting the option expire.
Experienced traders or market makers who buy and sell stocks to create a market might exercise OTM options at expiration. They do this mainly to reduce risk. These professionals aim to gain an advantage in each trade, avoiding significant risks by hedging positions—buying other investments simultaneously to minimize potential losses.
Let's say a trader is selling 2,000 shares of a stock (XYZ) and owns 20 XYZ 50 calls (the right to sell at ₹50) that are about to expire to reduce their risk. They want to cover the sold shares before the expiration (in a situation where the stock price is dropping) and offers to buy back the 2,000 shares at ₹49.98 each.
Now, imagine the stock closes at ₹49.99 on a Friday. The option is just one penny out of the money because the stock price was falling, and this trader didn't get the price they aimed for.
However, because the buyer had protection against a big loss from the 20 XYZ 50 calls that expired, holding onto the short stock position wasn't preferred by the trader. So, the buyer exercises the calls. Instead of paying ₹49.98, the trader must pay ₹49.99 (the strike price for the calls). This is okay for the trader and is better than holding onto the risk over the weekend.
"Carrying the risk over the weekend" means not using options when the market closes on Friday. Imagine news about the short sale comes out on Friday after the market closes. The stock's opening price on Monday will probably be lower than Friday's closing price, causing more losses for the trader if they didn't exercise their options on Friday.
The price would likely drop over the weekend as demand decreases. Call and put owners, who know about the upcoming short sale before the option exercise cutoff time (around 4:30 p.m. ET), start taking action.
Owners of slightly out-of-the-money (OTM) call options tell their brokers not to exercise those options. Similarly, owners of slightly in-the-money (ITM) put options will instruct their brokers not to exercise them.
When Monday morning comes and the stock market begins, the consequences of whether people decided to exercise or not exercise their options on Friday become apparent, leading to significant losses for those who held options for that particular stock.
This worst-case situation doesn't occur frequently. It's shared to explain how exercising out-of-the-money (OTM) options can impact and how to lower risks associated with call and put options.
Out-of-the-money (OTM) puts that expire worthless don’t hold value, but they can lead to profitable trades if the stock price drops. In such cases, even though the OTM put isn't in the money, its price might rise, allowing you to sell the put for a profit before it expires. An option's delta, which gauges an option's sensitivity to changes in the stock's value, is helpful for this type of trade.
Usually, you need special permission from your brokerage to trade options. After getting approval to upgrade your brokerage account, you can buy options by placing a buy order similar to buying stocks. Remember, option contracts have lower trading volume compared to the actual stock, so this lack of activity might influence the prices you get when using market orders.