The Right to Exercise an Out of the Money (OTM) Option
Understand an Out of the Money Option and How to Hedge It
Trading using options is a method traders use to try to purchase investments at an optimum price. An option can be exercised, or not, depending on the owner of the option. Two of the options for consideration are the put (the right to sell at a certain price) and call (the right to buy at a certain price) options.
Out of the money (OTM) refers to a situation in which an investor has purchased a call or put option on an investment. When an option is purchased, a strike price is placed at which to sell or buy the asset, regardless of the closing price.
When the strike price is higher than the market price, the option is referred to as being OTM (the buyer would pay more than the asset's market value).
When a Buyer Might Exercise
Exercise is a term that refers to initiating action on an option. In other words, exercising the right you purchased to have an option to buy or sell at the price you agreed on.
OTM options almost always expire worthlessly. However, there are situations in which an OTM call owner chooses to exercise their option.
When an option is OTM by one or two pennies it is possible, however unlikely, that the option owner would want to exercise. When the option is OTM and expiration arrives, the investor accepts the 100% loss of their purchase price and allows the option to expire.
Professional traders or market makers (someone who purchases stocks that are being sold by an investor, then resells them—essentially creating a market), will have instances in which they do exercise OTM options (at expiration).
The primary reason is to eliminate risk. Professional traders earn their money by trying to find an edge in each trade. They do not "play the market," and they do not accept large amounts of risk. Therefore, they prefer to hedge positions (purchase other investments at the same time that will minimize any losses) and minimize the chances of losing money.
Examples of OTM Exercise
A trader is short 2,000 shares of a given stock (XYZ) and owns 20 expiring XYZ 50 calls (sell at $50, to reduce risk) as a hedge. He wants to cover the short stock prior to expiration (in a declining price situation) and enters a bid of $49.98 for all 2,000 shares.
Consider what happens when the stock closes at $49.99, on a Friday. The option is out of the money by one penny (because the price to purchase was dropping), and this market maker (MM) did not get the stock price they wanted.
However, because of the buyer's protection against a large loss (the 20 XYZ 50 calls) expired, the risk of holding a short stock position is not what the market maker prefers to do. Thus, the buyer exercises the calls.
Instead of paying $49.98, the MM is forced to pay $49.99 (the strike price for the calls). That is acceptable for this trader and is better than carrying risk over the weekend.
Carrying the risk over the weekend is a term for not exercising when the market closes on Friday. Consider that news of the short close is issued Friday after the market closes. Monday's opening price for the stock will most likely be lower than Friday's closing price, increasing the losses for the MM if they did not exercise on Friday.
The price will be lower because demand would drop over the weekend. Call and put owners (investors that purchased options to buy or sell at certain prices) who learn about the pending short close before the cutoff time for option exercise (about 4:30 p.m. ET) begin to take action.
Owners of slightly OTM call options notify their broker to not exercise those options. Also, owners of slightly ITM (in the money) put options will instruct their brokers to not exercise.
Neither of these moves is automatic. To exercise an OTM option, or allow an ITM option to expire, 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 decisions result in a large loss for anyone with an option on that specific stock.
This worst-case scenario is not one that happens very often. It is meant to help you understand the exercise of OTM options, the effect it can have, and how to reduce the risks of call and put options.