long OTM puts at expiration - why the nasty surprise?

W

wmtrader

Can someone please explain how long OTM puts get assigned at expiration? I assumed they expired worthless, but apparently not.

As a newbie I usually avoid expiration week, but I could not avoid it as I ended up with some puts in a paper trade that I could not figure how to sell (as they were worth $0). I ended up being stuck with short stock (and a big theoretical loss) I was not expecting.

Friday 15th April 2011 on QQQQ. I had the remains of a BWB where I had bought back the short position earlier when it was around $0.10.

This left:
3 long puts at 42
3 long puts at 52

I tried to sell them in expiration week but they were worth $0.00 and the system did seem seem not let me sell them (even when I tried selling for $0.05). I thought as they were worthless it would not matter.

Last Friday (15th April 2011) QQQQ was hovering around 56.6 so I assumed the puts being so far OTM would expire worthless. Much to my surprise today (the Monday after expiration) I find that I had been assigned 600 short QQQQ at an average price of $47. The position shows a loss of around $4900 today with QQQQ at around $55.

Can someone please tell me why the long OTM puts ended up as short stock instead of expiring worthless? QQQQ had gapped down a bit today, but that was after expiration.

Also what is the best way to handle puts worth $0.00 if in order to get rid of them in case something weird happens.

Thank goodness for paper trading!

Thanks in advance.

William
 
What paper trading system are you using? Maybe it's a "feature" (bug) of their paper trading software.

Did you use a market order? For real trades I think you should be able to notify your broker not to exercise. This usually comes into play if you are right at the money at the close.
 
An option contract is the "right" to do something. The buyer (long position) owns this right. The seller incurs the "obligation" to perform should the owner (buyer) exercise his right.

If you were long (buyer), unless you exercised your right explicitly or implicitly by prior arrangement with your broker, you should not have been exercised.

Now, you wrote that you were long puts. A put is the right to force the seller of the contract to take stock should you choose to exercise that right. Yet you also wrote that you ended up with stock. Something does not make sense here. There is no need to sell a "right." Letting a right expire has no obligations on the owner. Furthermore, it makes no sense to try to sell something (.05) that is quoted as .00. Why would anyone pay you for something that is worthless. I suspect you were short and not long your positions.

Finally, the settlement for an option is determined by the opening of trading the day after the option trading ceases. Therefore, you are always exposed to market gap risk when you hold an option through expiration. Some indexes, like the RUT (Russell 2000) contain lightly traded stocks which may not open the day after trading ceases. If this happens, settlement rules kick in an settlement is determined. Thus, for options which cease trading on Thursday, may not be settled until Saturday.
 
He ended up with short QQQQ because that's what happens if long puts are exercise and there is no QQQQ in the account to sell. QQQQ must have been quoted below the PUT strikes at expiration. In any case, in a real money situation you would just instruct your broker not to exercise. This whole episode may be some artifact of the paper trading algorithm.
 
Quote from wmtrader:

. . . assigned 600 short QQQQ
More...
What kind of option will sell an ETF/Stock short when exercised?

A Long-Short Put or a Short-Long Call? (sarcasm)
 
Might be a paper trading hiccup. Definately check it out, though!

My general rule of thumb is to close out my expiring positions on Wed or Thurs of expiration week just to avoid any problems - technical, economic, political, natural, idiotic, whatever - that may come up on expiration Friday when time to adjust an existing position is not on your side[1] and everyone is juggling to exit/roll their positions.

Moreover, at my broker, if a short option is .05 or less I can buy it back for free, which I appreciate as a form of risk management.

Just my 2 cents.


[1] As I recall, wasn't it in '08 when the FOMC did an out-of-cycle rate cut on expiration Friday? Folks who on Thursday night were nicely profitable on their trades and had a market gap open hard against them on a day when time most certainly wasn't on their side.
 
I show the low on QQQ to be 56.28 for Friday. So must be a glitch in their system.

There also was a fairly recent name change, from QQQQ back to QQQ (again). Maybe that fouled things up...
 
Many thanks guys for your comments.

Being a newbie I was worried that I had misunderstood something fundamental about options, but your replies helped me realize something else was going on.

it turns out it was a quirk in the thinkorswim paper trading platform. Here is their reply when I asked why the far OTM puts were exercised.
---
It’s quite obvious that the exercise was processed in error as the options were OTM. If you wish, we can remove the exercise on the 600 short from your account. Be aware this would not happen in a live account as our processes are different from a live account compared to a demo account.
---

Thanks to all of you made comments/suggestions.

:)

William
 
Quote from HowardCohodas:

An option contract is the "right" to do something. The buyer (long position) owns this right. The seller incurs the "obligation" to perform should the owner (buyer) exercise his right.

If you were long (buyer), unless you exercised your right explicitly or implicitly by prior arrangement with your broker, you should not have been exercised.

Now, you wrote that you were long puts. A put is the right to force the seller of the contract to take stock should you choose to exercise that right. Yet you also wrote that you ended up with stock. Something does not make sense here. There is no need to sell a "right." Letting a right expire has no obligations on the owner. Furthermore, it makes no sense to try to sell something (.05) that is quoted as .00. Why would anyone pay you for something that is worthless. I suspect you were short and not long your positions.

Finally, the settlement for an option is determined by the opening of trading the day after the option trading ceases. Therefore, you are always exposed to market gap risk when you hold an option through expiration. Some indexes, like the RUT (Russell 2000) contain lightly traded stocks which may not open the day after trading ceases. If this happens, settlement rules kick in an settlement is determined. Thus, for options which cease trading on Thursday, may not be settled until Saturday.
More...

Howard you should really have a better understanding of what you own, for your own protection. As mentioned, you don't want to be unexpectedly long or short a stock and be subject to gap risk over the weekend. Here is a link to a CBOE page that explains certain aspects of expiration, exercise, etc.

http://www.cboe.com/LearnCenter/Concepts/Beyond/expiration.aspx
 
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