Put your Mind at Ease

Doc Maher adds to the Expiration Maintenance series.

This entry is on long puts and expiration. Nicole Wachs wrote two other entries on this topic. Dirty Calls deals with long calls at expiration. Spreads Can Be Messy explains some scenarios with short call spreads.  Unfortunately I don't quite have her flair so I don't have a really catchy title. In any case the point I want to make is that it is best to understand what will happen if you are holding long puts at expiration. Here are some questions you may be asking yourself:

If I own a put and the stock finishes below my strike at expiration, what happens to my account? Is the put that I own automatically exercised? Will I need enough money in my account to actually short the stock? Where is my risk?

Just like calls, puts that are in the money will be automatically exercised at expiration. And with the new rule, in the money is $0.01 in the money. 

So let's say that you hold a put on the proverbial XYZ stock at a strike of $75. What happens when this option expires? (This is Play 2 in the Options Playbook, under Education. This option trade requires Level 2 option approval and available capital to cover the cost of the option and commissions.)

Scenario 1 - XYZ is at or above $75.00. In this case your put is worthless and basically it just goes away, no commission, no fuss. Monday (assuming it expires on the regular schedule) you got nothing. The put just expires.

Scenario 2 - XYZ is at or below $74.99. In this case your put will automatically be exercised. This means that you will sell to someone 100 shares of XYZ at $75.00 for every contract you own. But maybe ‘you don't got no XYZ to sell', then what? Well you will end up short 100 shares of XYZ and you will have 100 x $75.00 = $7500 in your account. Your option will be gone.

What this means is that you will have sold 100 shares of XYZ that you didn't own. Often I get asked how you can sell something that you don't have. Well the way it works is the broker ‘borrows" the stock from someone else and gives it to you to sell. At some point you have to give it back, so to close this position you simply buy 100 shares of XYZ. Those shares go back to where you borrowed them from (more or less) and that closes your position.

This may be fine if XYZ stays below $75.00 because you sold at $75 and if you get to buy XYZ at some lower price you net the difference. This is the old buy low and sell high thing except we sold first and bought later.

The major issue here is that there is risk in a short stock position. What if the stock goes up? Well then you will have to buy it at a higher price than you sold it and you would lose the difference. Unlike long stock where your risk is limited to the price of the stock (XYZ can only go to $0), short stock has unlimited risk. The reason for this is that there is no limit to how high the stock can go. OK it's probably not going to go to $1,000,000 however there is nothing stopping it. This is the reason that you can't hold a short stock position in your IRA.

I said that you have an additional $7500 in your account. This cash is tied to the liability of being short 100 shares of XYZ. At some point you will need to buy back those shares. Of course there is no guarantee you will be able to do that for less than $75. So the broker won't let you do this unless you have reserves in your account to cover any potential losses.

This is referred to as margin and is 50% of the share price to initiate a short position. Shorting this stock would require you to have $3750 in your account, in addition to the $7500 deposited when the short sale took place. One more thing, since you borrowed the stock you also will have to pay any dividend that the stock pays back to the owner. Remember - you're the "borrower" not the "owner."

If your account falls short of this margin amount (or the broker suspects that it will) then the broker may do any of the following:

• 1. Call or email you during trading hours to alert you of an in-the-money open position.
• 2. Liquidate an option position that may become problematic (sell to close your put in this example) so that automatic exercise (or an inevitable short stock position) is avoided.
• 3. Liquidate (buy back) the resulting short stock position in the after hours market or during regular hours on the next business day.

In fact if at any time during the period that you are holding a short stock position your account fails to have enough margin, you can expect the position to be closed without your knowledge or permission. Any position that may result from an automatic exercise or assignment is ultimately the customers' responsibility.

There is nothing wrong with being short stock, you just don't want it to be a surprise. So I usually advise people to be proactive and close out long put positions before they get automatically exercised, unless you are prepared to take the short position in the stock.

--Doc Maher

"Income Trader"

DocMaher Trading LLC

All-Star Commentator

Nicole Wachs contributed to this blog.

Options involve risk and are not suitable for all investors.

Please read Characteristics and Risks of Standardized Options.

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

Jonathan F. Maher, PhD has a professional business relationship with TradeKing.