The Right to Exercise an Out-of-the-Money (OTM) Option

Understand an Out-of-the-Money Option and How to Hedge It

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Trading using options is a method that 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 the 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 at which to sell or buy the asset is placed, regardless of the closing price.

When the strike price is higher than the market price, a call option is referred to as being "OTM" (i.e., the buyer would pay more than the asset's market value). Similarly, an OTM put would have a strike price below the current market price.

Key Takeaways

  • A put option gives you the right to sell a stock at a certain price, while a call option gives you the right to buy it at a certain price.
  • "Out of the money" (OTM) refers to a situation where the strike price is higher than the market price for a call, or lower than the market price for a put.
  • Professional traders may exercise OTM options at the time of expiration in order to eliminate risk.
  • “Carrying the risk over the weekend” refers to not exercising options when the market closes on Friday.

When a Buyer Might Exercise

"Exercise" is a term that refers to initiating action on an option. In other words, exercising the right that you purchased to have an option to buy or sell at the price you agreed on.

OTM options almost always expire worthless. 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 it. 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 (people who purchase stocks that are being sold by an investor, then resell them—essentially creating a market) will have instances when they 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 (i.e., purchase other investments at the same time that will minimize any losses) and minimize the chances of losing money.

Examples of OTM Exercise

Suppose 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 position 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 Risk

"Carrying the risk over the weekend" means not exercising options when the market closes on Friday. Consider that news of the short close is issued on 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 their options on Friday.

The price would be lower, because demand would drop over the weekend. Call and put owners (investors who 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 brokers to not exercise those options. Owners of slightly ITM (in the money) put options will instruct their brokers to not exercise them.

Neither of these moves is automatic. To exercise an OTM option or allow an ITM option to expire, you must notify your broker before their cutoff time.

When Monday morning arrives, and the stock opens for trading, the wisdom (or folly) of Friday's exercise/do-not-exercise decisions results in a large loss for anyone with an option on that specific stock.

Final Thoughts

This worst-case scenario does not happen 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.