The Right to Exercise an Out of Money (OTM) Option
Let's start by looking at a question from a beginning options trader: "Please forgive the basic nature of my question -- my options trading career is in its infancy. When an option is OTM (out of the money) at expiration, does it always expire worthless? Is there a situation where an option owner would want to exercise an OTM option?
This is one of those elementary concepts where most new traders would assume they know the answer, and not bother to ask.
Understanding the most basic option concepts is essential before you can expect to trade options with real money.
Consider the Following...
The owner of an option has the right to exercise. That right is not revoked just because the option is out of the money. Thus, OTM options almost always expire worthless. However, there are situations in which the OTM call owner does exercise.
When an option is OTM by one or two pennies, it is possible – unlikely – but possible that the option owner would want to exercise. The typical retail customer who buys options as a speculation would never exercise. When the option is out of the money and expiration arrives, the individual investor accepts the 100% loss of his/her purchase price and allows the option to expire.
However, if you consider the scenario from the point of view of the professional trader or market maker, then there are instances in which the trader does exercise OTM options (at expiration).
The primary reason is to eliminate risk. Professional traders earn their money by trying to find an edge with each trade. They do not "play the market," and they do not take a lot of risks. Therefore, they prefer to hedge positions and minimize the chances of losing money.
Example 1. A trader is short 2,000 shares of a given stock (XYZ) and owns 20 of the expiring XYZ 50 calls as a hedge.
He wants to cover the short stock prior to expiration and enters a bid of $49.98 for all 2,000 shares. Consider what happens when the stock closes at $49.99. The option is out of the money by one penny, but this market maker failed to buy his/her stock. Sure, that person can do nothing and come to work Monday morning still short those 2,000 shares. However, because his/her protection against a large loss (the 20 XYZ 50 calls) expired, the risk of holding a naked short stock position is not what the market maker prefers to do. Thus, the calls are exercised. Instead of paying $49.98, the MM is forced to pay $50 (the strike price). But that is acceptable and is far better than carrying risk over the weekend.
Example 2. Even if the option is OTM by a dollar or two, it could be exercised. It is also very rare, but it does happen. Think about what happens when the news is issued Friday, immediately after the market closes. When it is 'obvious' that the news is very good or very bad -- making it highly likely that Monday's opening price for the stock will not be near Friday's closing price -- then call/put owners who learn about the news before the cutoff time for option exercise (about 4:30 PM ET) will take action.
Owners of slightly OTM call options notify their broker do exercise those options. Also, owners of slightly ITM (in the money) put options will instruct their brokers: Do Not Exercise. NOTE: Neither of these moves is automatic. To exercise and OTM option, or allow an in-the-money option to expire worthless), you must notify your broker before that broker's cutoff time.
When Monday morning arrives, and the stock opens for trading, the wisdom (or folly) of Friday's exercise/do not exercise decision will become obvious.
It is a rare event and is being discussed for educational purposes so that you can understand why OTM options are occasionally exercised.