Dirty Calls

Tidying up your account for Expiration.

Get your mind out of the gutter! :P

I am referring to getting your affairs in order. Here are a few common questions that may be running through your mind this week.

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

As I have mentioned before, trading necessitates a responsible attitude and an awareness of important events. Few are more important than monthly expiration. Before I get into an example, now is a good time to alert traders that there is a rule change coming next month that will shake things up a bit.

Currently, as dictated by the Options Clearing Corporation (the OCC), a standard equity option will be automatically exercised if it is in-the-money by five cents or more. On June 21, 2008, this amount will be reduced to one cent. You can read the full memo here. The threshold for index options and fixed return options is already one cent. Now let's continue with our discussion.

Let's say you buy 1 May 75 call for $3.00 (Play 1 in the Options Playbook, under Education). This option trade requires Level 2 option approval and available capital of $300 plus commissions ($3.00 x 100). The most you can lose with this call position is $300 plus future transaction costs. You decide to hold your position through May expiration and you do not sell to close your call.

Scenario 1 - The stock is below 75.05 at expiration. The option will expire worthless. The premium you paid will be lost, resulting in a loss of $300. On Monday, you will have no open positions for this trade.

Scenario 2 - The stock is at or above 75.05 at expiration. Your option is automatically exercised. This means you will buy 100 shares of stock for $75 per share. This investment (after the exercise is complete) is $75 x 100 = $7500. On Monday, you will be long 100 shares of stock, with no open option positions.

As you can see, the max loss of $300 from Scenario 1 has ballooned to $7800 in Scenario 2 ($300 + $7500). Your stock position is subject to market fluctuation, just as if you purchased the stock in the open market, which can be a lot worse than losing just $300 on the call trade. This is because the price of the stock may decrease sharply between the market close on expiration and any subsequent sale on Monday. (Or Tuesday if Monday is a holiday.)

Up to this point, I have only addressed the risk to the trader. However, there is risk for TradeKing as a brokerage firm. As we often hear from our clients, our low commissions, and no-nonsense cost structure are loved by many. In order to keep it this way, we keep a watchful eye on our costs. This includes monitoring our customers' activity and sometimes taking action. If your account does not have an available balance high enough to pay for the automatic exercise in Scenario 2 (or looming assignment if you are short contracts) there are several things we are permitted to do.

• 1. We may call or email you during trading hours to alert you of an in-the-money open position.
• 2. We may decide to liquidate an option position that may become problematic (sell to close your call in this example) so that automatic exercise (or inevitable assignment) is avoided.
• 3. We may not monitor your account during trading hours, but later liquidate the resulting stock positon in the after hours market or during regular hours on the next business day.

Obviously this list of actions is not fun for us, or for you. But if we see a financial obligation developing that we do not think our customers can meet, we are obligated to mitigate it as quickly as possible. Across the board, the best remedy is prevention. The only way to prevent further market risk to your account is for you to place an order to sell your call option before the close on the last day of trading for that expiration month. As with any trade, you can close the position whenever you see fit, but this day is the absolute last opportunity to exit. To assist in submitting these orders, you may choose to utilize our Good Until Cancelled function (GTC orders) or Advanced Orders.

No one likes to walk in on Monday to a surprise left over position, nor receive a call from our Margin Department about a problematic situation. The best way for you to protect your account and your equity is to be proactive, plan ahead, and stay informed. Be mindful of the positions you have open and know when expiration occurs for the product you are trading (this can vary). As you may already be aware, any position that may result from an automatic exercise or assignment is ultimately the customers' responsibility. The simplest way to deal with this is in advance, when action can still be taken. Don't wait until the last minute and be sure to keep your contact information up to date.

Regards,

Nicole Wachs

TradeKing Staff

Part of this blog was previously posted in Spreads can be Messy.

For my past blogs, click here.

Options involve risk and are not suitable for all investors.

Please read Characteristics and Risks of Standardized Options.

Image: Dirty Call by Bernardo Castanho on Flickr