Exercising out of the money options?

Mark D Wolfinger on

Hi Mark

I trade options by selling them and all this while I am unaware that out of the money options could be exercised. A friend of mine recently told me that it's possible although not probable this would happen. Is it true? I have always thought by definition, if an option is out of the money, it cannot be exercised and hence,  i have always tried to let my out of the money options expire worthless as much as possible. Would greatly appreciate any kind of info you could provide. Thanks very much!

Just an addendum, I could see a scenario like this being profitable the end of the day of the last Friday before options expiration and a stock suddenly spikes after hours to be in the money...
Leo Chuah

Hello Leo,

Yes, it's true. The owner of an option has the right to exercise any option. The fact that it's out of the money does not cancel that right.

My feeling is that allowing options to expire worthless is far, far riskier than many believe - especially when there is so little to gain. Of course, if you sell options at low prices (I shudder at the thought), then paying a few pennies to close those positions won't work. But, if you receive a decent premium, then surely you can afford to pay a nickel or dime to cover - especially when there are several weeks remaining before the options expire. Why take any risk for such small potential profits?

Getting back to your question, consider this scenario:
A market maker is long 50 Jul 40 calls and is short 5,000 shares as a hedge. It's late in the afternoon on expiration Friday and the stock is trading at 40.00. Our MM wants to buy 5,000 shares to cover his short, and decides to bid 39.97. Time passes, the stock trades as low as 39.98, but our MM buys zero shares. The stock closes at $39.98.

The MM has two choices:

Do nothing, and go home for the weekend with a position of short 5,000 shares
Exercise those out of the money calls, and go home flat, with zero risk

Which do you think the MM will choose? The decision is easy. He exercises. Of course, he can try to pay $39.98 in any after hours trading before exercising. But he doesn't have much time.

OTM options are exercised - not often - but there is no guarantee of not being assigned an exercise notice just because the option is worthless.

As to your addendum, that's also a risk. The problem is that most individual investors will be unaware of that after hours spike and will not exercise their options - which officially finished out of the money. But you can be certain the professional traders will be aware of the news, and exercise.

It's very simple to exercise after hours , but the time window is short. Each broker has its own cutoff time, but all the exerciser has to do is notify the broker "Do exercise these options" - and then supply details.

Mark

--
Mark D. Wolfinger
The Rookie's Guide to Options:
The Beginner's Handbook of Trading Equity Options
website:  http://www.mdwoptions.com
blog: http://blog.mdwoptions.com/options_for_rookies
Free eBook: http://www.mdwoptions.com/freebook.pdf

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