i. What is options expiration risk? (US options and futures)
Expiration risk refers to the potential of creating a large, unhedged position in an underlying due to the exercise/assignment process at expiration. If our risk team determines that an account is subject to expiration risk, then the option(s) position may be closed out before the market close on the expiration day.
Characteristics of expiration risk
The following attributes of exercise/assignment of equity options at expiration create the potential for expiration risk:
- All long options that are in-the-money by $0.01 or more automatically exercised unless the long option holder submits a "Do Not Exercise" request.
- All other long options are not exercised unless the long option holder submits an “Exercise by Exception” request*. This primarily affects customers that hold a long options position that expired OTM, but due to after-hours price action, it becomes ITM.
- Professional traders & market makers have until 4.30 PM CT on expiration to submit “Do Not Exercise” and “Exercise by Exception” requests to the OCC. (you need to submit these instructions to the tradedesk by 3.30 PM CT)
- Exercises & assignments are processed overnight, so if you are assigned on a short option, there is no way to know until after expiration.
* An option is considered ITM/OTM based on the closing price. Additionally, "Exercise by Exception" requests require the account to have enough buying power to process an exercise request.
What about defined-risk spreads?
Although defined-risk spreads allow you to know your theoretical profit or loss at order entry, expiration day adds another level of complexity. There is no definitive way to know if you will be assigned on a short option(s) position in your account after the market closes on the expiration day. Although a short option(s) position may have expired OTM based on the closing price, after-hours price action can turn an OTM short option into an ITM option. As a result, spreads (verticals, iron condors, etc.) tend to create the most expiration risk. The risk comes from the long options expiring by the time you know whether or not the short option(s) are assigned. In other words, the defined risk position no longer becomes a defined-risk.
Examples of expiration risk
Example 1: Long Options
- Account deposits $5,000.
- Account buys 500 contracts of out-of-the-money SPY calls that are expiring that day for $0.10. (Total cost = $5,000)
- The account doesn’t sell the SPY calls before the market closes, they close in-the-money, and the account doesn’t submit a “Do No Exercise” request.
- SPY is down $3.00 the following day.
In the situation described above, all of the calls would automatically exercise, and the account would be long 50,000 shares of SPY the following day. If SPY were down $3.00 on the next trading day, then the account would lose $150,000.
Example 2: Option Spreads
- Account deposits $10,000.
- Account sells 200 at-the-money dollar wide put spreads in SPY that are expiring that day for $0.50. (Buying power reduction = $10,000)
- The spreads are out-of-the-money at the end of the day, so the account doesn’t close the position.
- SPY is down $3.00 in the extended hours and down $4.00 the following day.
In the situation described above, the short puts will likely be assigned, but there is no way to know for sure until the following day. If the puts were assigned, the account would be long up to 20,000 shares. If SPY was down $4.00 on the next trading day, the account would lose $80,000.
How can I eliminate expiration risk?
The only way to eliminate expiration risk is to close short options before expiration. However, you may submit an appropriate "Do Not Exercise" and/or "Exercise by Exception" requests for long options that expire ITM.
Do not exercise (DNE) requests only apply to long option positions. If you have a short option that expires in-the-money, you cannot request a DNE. As a short options holder, you are obligated to deliver or take delivery of the assigned position for a short call or short put position, respectively.
Sell to open restrictions for day-of expiration options
Any equity or ETF options order with a short leg (sell to open) will be prohibited during the last 30 minutes of trading before the market closes. The 30-minute restriction applies to selling (to open) naked calls or puts, as well as a long or short option spread orders since defined-risk spreads can potentially pose expiration risk. Any order submitted in the last 30 minutes of trading on expiration day will receive a "Sell to open order cannot be sent 30 minutes prior to market close on day of expiration" pre-flight error message in the order ticket after clicking Review and Send.
