Fun and Games in the Big Apple—When Is the Trade Over?

This brings us to the energy markets, which undoubtedly offer us more opportunities for endplay trades than any other class of market. However, we must be even more alert than usual when attempting an endplay in these markets, because the rules of the New York Mercantile Exchange are a little bit odd regarding option expiration.

What happens with expiration, in most months in the NYMEX energy contracts, is really quite fascinating . . . until
you put your capital at risk.As Yogi Berra once famously said, “It ain’t over ’til it’s over,” and nowhere, nowhere, in the world of trading does this amusing tautology apply more than in option expiration on most of the NYMEX energy contracts.If you aren’t a serious option trader, option writer especially, you might very reasonably believe that when an option stops trading, it has expired by rule.

Your view is perfectly sensible, but now, my friend, welcome to New York.Options on NYMEX energy contracts stop trading at the close of the market on their scheduled last trading day. So far, so good, and utterly normal.But, by rule, they can be exercised by the owner of the options for another couple of hours after the close. This extension still isn’t a problem for option writers. Fine, allow the option owners to exercise away, and more power to them.

The “gotcha” condition comes now. Unless the last trading day for the options happens to be a Friday, the after-market NYMEX ACCESS session opens for trading before the exercise period elapses. In plain English, if we’ve written an option that has, notionally, expired out-of-the-money, but only by just a little bit at the market close, then, during the ACCESS session,the market can (and does occasionally, bet your life!) move so that the written option is now in-the-money.

The $64,000 question is now: will this option be exercised, and will we be assigned a position? The answer is: probably, because almost every brokerage employs the so-called 1-tick rule. To protect careless traders who forget about options they own, virtually all brokerages will exercise the option on behalf of the client if it is even one tick in-the-money (ITM), unless they have received instructions from the client to the contrary.

Good for the brokerages; they’re looking out for the client’s interests. It doesn’t help us, though. If the option we’ve written does move into the money early in the ACCESS session, we may have a problem. The ugly part is that this problem can’t usually be resolved.What we’d like to do in this case, when the option we’ve written has moved into the money after the market close, is wait until the last few minutes before the option can no longer be exercised.

If it’s ITM, we’ll buy a future to offset against a short call being exercised or sell a future to clear off a short put that might be exercised. If we do so, then, when the option is exercised,we’ll be assigned the opposite position, and we’ll end up flat, out of the market, which is exactly what we want. In theory, that’s the way things will proceed. Would that matters were so straightforward.

In any market that has an afternoon after-market session, occasionally,the after-hours market will move so that our short option is just a little bit ITM, 5 points perhaps in crude oil, or a half-cent in natural gas. Here’s a question for you: will the owner of the option exercise it under these conditions?“Hey, you said the brokerage automatically exercises ITM options at expiration! What’s the deal here? Of course the option will be exercised.” I did say that, it’s absolutely true, and the brokerage will indeed exercise the option . . . unless the client has told them not to.

There’s absolutely nothing to stop a trader from placing an order with his broker something like “Exercise 2 CLZ 25.00 calls at expiration, only if CLZ is above 25.07.” Orders like this are fairly common, and, if you consider the point for a moment, you’ll see why. Some considerable fraction of the traders who buy options either don’t want the underlying futures position or don’t have enough trading capital to hold the position.

If the option they own is only a tiny amount ITM, it may well be the case that exercising their option and trading out of the futures position costs more than it’s worth to them, and they’ll simply abandon the option. This is where our problem originates.

At expiration, the exchange matches up long and short option positions, generally according to the length of time the long/short position has been held, and then doles out the assignment notices. If the trader who owns the option we sold simply abandons the position, we won’t know about it, usually, until tomorrow morning. In short, we will not know if we have a position in the market, and this is major-league bad news.