#9 - What Happens When A Stock Expires Between Strike Prices?

Episode of: The "Daily Call" From Option Alpha

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Oct 3, 20179m
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#9 - What Happens When A Stock Expires Between Strike Prices?
Oct 3 '179m
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Hey everyone, welcome back. In today's call, we're going to talk about what happens to a stock that expires between strike prices. This is a fairly common fear I guess that people have of trading spreads, whether it’s a credit spread or an iron condor that the stock may potentially finish or end the expiration month in between two different strike prices. To set the stage here and use an example, so we can visually think about this, obviously we’ve got videos on this topic on the website, so if you want to watch a video, but if you visually think about it, it’s not too bad either just in your mind. Let’s say that we’re trading something bullish and we are selling a 48 put option and buying a 46 put option. Let’s say the stock is trading at $50, so we sell the 48 put option, buy the 46 put option. It’s a very simple put credit spread trade. A bullish put spread is really what that's called. Our fear now is that the stock falls below our short strike of $48 and closes above the $46 put option that we bought. That's the fear of the stock closing in between this range and really, what would happen in between this range.

The first thing is that the assignment more often than not really won’t actually come until expiration week. The first thing is if the stock falls any time between now and expiration, as long as you’re not in expiration week, literally the last four or five days of expiration, there’s probably a low chance that you’re going to get assigned. Not a zero chance. I’m not saying that it’s totally impossible, but probably a small chance that you’re going to get assigned. We’ve done a couple of podcast on how often assignment actually happens and it’s not that often. In fact, when we go back and track our own trades, we get assigned less than 1% of the time and this is a couple of hundred trades. I think we’re almost over like 1200 trades or so. We’ve done a lot of trades and been assigned less than 1% of the time. The reality is that it’s not going to happen that often. If you do get to expiration week or if you just let the position go all the way until expiration and the stock closes in between those strike prices, any option first of all that’s in the money will get assigned or exercised, however you want to think about it. If you have a short put at the 48 strike and that short put is in the money which means that the stock is trading below the 48 strike, you are going to get assigned if you let it go all the way to expiration. That means you’re going to have to buy stock at 48 and you’ll have conceivably a stock that you can resell back in the open market for a lower price. That’s where the loss comes in.

Let’s say that the stock finishes exactly in between those two strike prices just to make our math very easy and make everything I guess easy to understand. Let’s say the stock finishes at $47, so it fell $3 from its initial price when we traded it at $50, fell down to $47. It’s now $1 in the money, so our short puts at 48 will get assigned and we’ll be required to buy a stock at 48 that is conceivably worth $47, so we’ll be out $1 per share. Now, our long options at 46 expired out of the money because the stock didn't fall down to 46. If we actually take it all the way to expiration, those long options expire out of the money. Now, if we're actually assigned before expiration and this is where it gets a little bit tricky, but follow along here with me. If you're assigned before expiration on your short 48 puts, you can choose to do one of two things. One, you can choose to just buy back the stock in the open market. One of the biggest fears that people have is that they have to have all this capital to hold the stock. You do have to have capital to hold the stock if you want to hold it longer than one day. But if you don’t want to hold it or if you don’t have the capital to hold it, all you have to do is just reverse the trade and sell back the stock in the open market. If you get assigned stock at $48 and now you’re long 100 shares, you can simply sell those shares back, same thing in the inverse for call options. If you are assigned short shares, then you can simply buy back those shares and close the stock positions. It’s actually very easy to manage and your broker can definitely help you walk through that if it’s your first time.

If you’re assigned early before expiration, you can also choose if you want to, to go ahead and exercise your long 46 put option, so that that exercise of the long 46 put option basically cancels out or negates the shares that you were assigned. Again, if you're assigned shares on the 48 put option that you are short, you can choose to exercise the 46 strike put option that you are long because you're the option buyer, so now it’s your choice and those shares cancel out. You get the choice to go… You got long shares and then you get short shares that basically cancel each other out and now, your stock is basically taken care of. That’s where covered strategy or risk-defined strategy like this comes into place. When you do spreads where you’re long one and short the other, the long option could protect the short option. It protects that difference. Now, you’re still going to lose the $1 in the price because the stock closed at 47 which is still in between the range. Your strike prices were 48 and 46. You bought stock at 48, you sold it at basically 47 in the open market, then conceivably on the long put option that you are long at 46, you can buy stock or short stock at 46 and sell it back at 47. You get this opportunity here to basically still lose about $1, that difference between the strike prices and where the stock is at that time. That doesn't really change. You have some choices, you have some options (no pun intended) if the stock is assigned or if the options are assigned before expiration day.

Now, if you actually go through all the way to expiration and you just forget about it and you’re assigned on the short 48 puts, you don’t have the choice then to exercise your 46 long puts because they’re not in the money, so they’re not automatically going to be assigned. In that case, you still would do what we talked about earlier which is just close out of your stock position. You didn’t make anything on those 48 puts, but you just simply closed out of the stock position and just reversed the trade. In any case, it's not that bad if the stock closes between your strike prices. What we always suggest you do though is you don't take all your trades to expiration because you don’t want to deal with assignment and exercise and most brokers actually charge much higher commissions to go through that type of process than just a regular option trade. If you are getting closer to expiration and you have a stock that’s dancing around, being a winner versus a loser, it’s probably better to just close the position, have a small gain, small loss or scratch on the trade and move on versus actually going through this process. But if a stock finishes between it, then that’s what’s going to happen. Anything in the money gets assigned or exercised. Anything out of the money on expiration day does not. It’s out of the money and it expires worthless.

Hopefully this was helpful. I know it might have been complicated maybe the first time and we definitely went through a lot of scenarios, there’s a lot of numbers being thrown around which is hard to explain on a podcast. But if you need help, just re-watch this video or check out some of the other videos that we have online. Until next time, happy trading!

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