An Education in Expiration

This week in the Options Forum, we trace point by point and play by play the trading patterns behind stock and index options closing in on expiration, and we give you one ex-trader's prudent advice on how to navigate expiration when your option goes in the money.

Hope you enjoyed the holiday. As always, keep sending queries to Options Forum. And hey, full name, rank and serial number.

Delta Dawning

I understand that generally speaking, the price of an options contract will track the stock price, point for point, when in the money.

This does not seem to be the case for index options (i.e. S&P 100, or OEX, and S&P 500, or SPX, index). Typically, what point movement in these indices would cause a point movement in the options price of that index?

-- David W. Smith

David,

With index options, time is money, even more so than with stock options.

Scott Fullman of Swiss American Securities helped explain what that means. His first axiom: "The index option will track point for point when all of the time value has eroded from the value of the contract."

Index options tend to hold time value much longer than individual stock options because they're generally more volatile and higher-priced.

"Plus, there is the 'cost-of-carry' factor," Fullman adds. "You pay more interest on a stock that trades at 200 than one trading at 20, and that cost of carry goes into that time-value portion of an option's price. So you have a greater time value on a higher-priced instrument such as an index."

Let's assume we're talking about call options: The deep in-the-money stock options move point for point because the probability that they will go out of the money decreases. (The amount by which an option's price moves for every $1 move in the stock is called delta.)

Index options are different, Fullman explains, because they "have a higher probability of moving back [out of the money] given how many points they can move in a day. Still, it depends on the index, the price level and the volatility."

Fullman uses the example of the Philadelphia Stock Exchange Gold/Silver Index, also known as the XAU. "If there are two weeks left until expiration, for example, and we're looking at the XAU, November 55 calls that are 13 points in the money. With two weeks to go until expiration, the call options are going to trade point for point and they're quoted 13 1/4 to 14. There's hardly any time value, and they're going to move almost point for point with the index, which is at 68.37."

A different scenario plays out in broader index options. "Look at an OEX option. A 30-point, in-the-money November 680 option is currently 30 points in the money; it's trading at 35 1/2 ($3,550) to 36 1/2 ($3,650); 83% of that quote is intrinsic value and 17% is time value."

The November 680 option and the underlying index probably would start trading point for point a day or two before expiration. "Just remember," Fullman warns, "erosion of a higher-priced option usually involves time value."

Exercise Caution

"To exercise or not to exercise," that is the question. Can you give me some guidelines concerning whether to exercise an option or close a position?

I recently was long a put on Inktomi (INKT Quote) on an expiration Friday.

Late in the afternoon, I exercised and covered the put. However, are there general rules so that "in the heat of battle" one can make a decision that will be profitable?

I was long the October 120 put purchased at 1 1/8. The bid was at 2 1/8. Instead of selling and closing the put, I exercised and purchased the stock at 118 3/4.

-- Greg Berger

Greg,

We brought in Adam Benowitz, ex-Amex trader and manager of the Apex Capital hedge fund, to take a crack at advice on how not to crack on expiration day.

To start, if you're long the Inktomi put, that means you own that put, which gives you the right to sell the stock -- in this case, at 120.

If you exercise the 120 put option, you have the right to sell, or "short," the stock at 120, minus the 1 1/8 ($112.50) paid for the put option. So, essentially, he shorts it at 118 7/8.

"Let's say it's 3:59 p.m. The stock market's about to close. If Greg sells the put, he makes a point ($100). He didn't do any stock transactions. If he exercises the put, he's got a chance to sell the stock at 120, but he would have lost the premium," Benowitz says. "So, by exercising, Greg shorted the stock at 118 7/8, and then bought it back at 118 3/4. If he exercises, he makes only 1/8 ($12.50) of a point."

Benowitz advises that simpler is better, and it doesn't make you money to be too clever by half: "If you just sell the put, it's a simpler transaction and you make a full point. That's an $875 difference."

His main warning is that investors should only exercise if they actually want to be short the stock fundamentally. "You're being too cute when you exercise and cover, especially if you're just a normal guy. Don't. You're making 1/8 instead of a full point, and paying more commissions," he says.

Last word? Generally, with an in-the-money option that you own, just cover the option as an option and don't bother with the stock, he adds. If you're in the money, do the simplest transaction possible unless the bid-ask spread on the option is tremendous. Very near expiration, an option should trade close to parity. That makes it even more counterintuitive to exercise and waste time with the stock transactions.

"Only exercise if you really want a position in the stock," Benowitz says. "Otherwise, it's wasting time."