Zombie puts & calls

August 18, 2016 09:00 AM
The great thing about options is that they allow you to define risk. The one exception—pin risk—can ruin your day. Here’s what you need to know.

Many options traders, including seasoned veterans, are often shell shocked when they get hit with the after effects of options beyond their expiration. If an option is “In the money” (ITM) at expiry the option is automatically exercised. Options “Out-of-the-money” (OTM) at expiry are not exercised. However there are circumstances whereby an ITM option is not exercised and an OTM is exercised. Those beyond the grave option experiences can be beneficial at times, but for most of us, it’s Hell. 

Pin risk means that the option seller gets “pinned” with the underlying futures contract. This normally occurs when the option is ITM and is therefore automatically exercised. In the case of a call, this means at expiry that the underlying futures contract is above the strike price of the call; in the case of a put, the underlying futures contract is below the strike price. With an American style option, at any time during the options life, the owner of the option can exercise the option (in an ironic twist of diction, the American style option owner has the “option” of exercising the option). This can occur anytime through the day of expiry. When this occurs the option writer is therefore pinned with the opposite side of this exercise. 

In the case of a call being exercised, the option writer is pinned with a short position with the short entry price being the strike price. For an exercised put, the option seller would be long the underlying futures contact at the strike. European style options are automatically exercised only at expiry and only if they are ITM.

Here’s a question: Does every option that is ITM at expiry get exercised? The logical answer would seem to be yes, but in fact the answer is no. Even though the vast majority do, not all ITM options get exercised. The technical term for these unexercised ITM options is “abandonment.” Under what circumstances does this occur? The answer is based on the fact that options not only have a day of expiration, referred to as expiry, but a specific time that the options can no longer be sold or bought on the day of expiry. However, in many markets the underlying futures contract continues to actively trade. This trading activity can move an option that was ITM at expiry and OTM a short time later.

Veteran option traders who actively trade options and hedge with the underlying futures contract have experienced these abandonments on occasion (see “Options naked straddles: A more modest approach,” Futures, January 2011). They seem to occur often in the crude oil market. Here is what happens: A trader sells a straddle (put and call at the same strike price) at 2:30 p.m. EST on expiry with the crude oil futures contract slightly above the straddle strike price. The assumption is that the call will be exercised and the put will not. The owners of all options have a certain amount of time to let the exchanges know they wish to abandon an exercise (option abandonment). The owners have a certain amount of time (usually until 4 p.m. for crude) to inform the exchange of abandonment.

“Letting go,” (right) shows an example from May 17, 2016 (the last trading day for the June crude options). After 2:30 p.m., the options are expired or dead. However the options are not officially exercised until that afternoon. Here the closing price of the underlying futures contract at expiry is at $48.30 (bar marked “A” on the chart), 20¢ below the 48.50 strike. At this point the 48.50 calls are OTM and the 48.50 puts are ITM. Therefore the 48.50 puts are on course to be exercised. However during the ensuing hour and a half crude prices continue to rise. They briefly go above the 48.50 strike at 3:10 p.m. and then retreat. Then it ends up above $45.50 by 3 p.m. (bar marked “B”). Seeing this, the owners of the options have the ability to abandon and ghost exercise. This is precisely what happened. Many, but not all, of the owners of the 48.50 puts abandoned the exercise of their options. This is called  “abandonment.” Many writers of these options will get pinned with a position in the underlying futures contract.

Zombie Options

Abandoned and ghost exercised options trading also can be referred to as Zombie Option activity.

What will happen is that the underlying futures closes beyond the call strike price at 2:30 p.m. but before 4:00, the futures contract retreats, thereby making the owners call option OTM. The owner therefore contacts the exchange and informs them of the abandonment. The option seller may have hedged the option by taking a position in the underlying futures. In the case of a call being exercised, they would have bought a futures contact. The exercise will cause a sell for the option writer in the underlying futures at the strike price. When hedged properly against a normal exercise process, nature takes its course because the exercised short position is offset by the long futures set up as a hedge.

However, when abandonment occurs, there is no option exercised and therefore the hedged position is not offset. This is called a “reverse pin.” You are taking care not to be pinned one way only to have financial Jiu-Jitsu on your position(s) and are now pinned in the reverse direction.

Another way this happens is when the option writer hedges by buying a deeper ITM option with the same expiration date as the one sold. Because the deeper ITM option is exercised on expiry, the trader should therefore be hedged, long the futures contract, due to one option exercise and short the futures contract on the other option exercise. Therefore, the positions are offset and flattened. When abandonment occurs, traders will find themselves reverse pinned because the option being abandoned, which was expected to create an opposite futures position and offset the deeper ITM being exercised, no longer occurs.

The options that are abandoned are randomly assigned to the various owners of these options. The exchange sends out a notice in the evening as to the number of options that were abandoned. The trader won’t know if their options were abandoned until their FCM and IB tells them. In the case of crude this usually happens between 8 p.m. and 9 p.m. EST. These can be some nervous hours especially if the underlying futures contract has moved during the evening hours going into the Asian sessions.

The process is the same for Ghost Exercises (Contrary exercise). The exchange sends out a notice in the evening as to the number of options that were contrary exercised. The trader won’t know if their options were exercised or not until they are informed by their FCM and IB.

Have a plan

One way of avoid getting pinned through abandonment or ghost exercise is to simply buy the options back right before the close, or buy down to the sleeping level. If the trader does this then abandonment and ghost exercises don’t affect them and they can spend their evening doing something more productive or relaxing.

However, buying options back with only minutes to go can be both expensive and painful. It’s not unusual to see extremely wide 
bid/ask spreads when the price is close to the strike and the trader is looking at buying back.

Another key, especially in crude, is to watch the market until 4 p.m. to see if ghost exercise and/or abandonment is a possibility. It’s important to have a game plan for all contingencies. In this case the trader is looking at a post-game plan. Because the option is dead—but wreaking havoc beyond the grave—the trader needs to be proactive.

First, have the contact numbers and e-mails of each FCM you have accounts with that might be affected by a ghost exercise and/or abandonment. Contact them directly and tell them specifically which options are in jeopardy. You will want to be informed immediately upon knowing whether your position was abandoned or contrary exercised. If you don’t do this, you run the risk of not knowing about a position in your account until the next day and at that point the underlying futures contract may have moved against you.

Once you find out which accounts were affected, take immediate action to flatten your position. Let’s say an OTM call option got ghost exercised and you were one of the lucky winners of that assignment. That means that your account is now short X number of futures contracts depending on the number of options that got assigned to that account. The beauty of futures is that they trade nearly 
24 hours from Sunday evening through Friday afternoon, whereas stocks are pretty limited to day sessions. 

By either buying options back right before expiry or executing a post-game plan for ghost exercise and abandonment, the trader can reduce the exposure of these zombie option attacks. 

Long weekends

We used crude as our example because it has a propensity to make after market moves that affect option exercises, and 80% of the time crude options expire before the end of the week. Options that expire on Friday present a unique problem because the first opportunity to flatten the positions will be Sunday night. This can screw up your binge-watching of the Walking Dead series, but business is business and these positions need to be flattened as soon as possible unless you like the thrill of uncertainty.

A key is knowing the official closing price. Many charting services will be off the official closing price by several ticks. This can be dangerous when straddling (pun intended) an ITM versus OTM strike. This will catch some traders totally off guard as they come in the next day with positions that were affected by Zombie exercise activity.

One remedy is to buy the options back just minutes, before they expire. 

Knowing the time that the exchange has to be informed is a good time to measure whether the option is ITM or OTM. Even though the option can no longer be bought or sold it still has a strike price. If the futures contract price is beyond the strike at notification time then there is a good chance it will be exercised and not abandoned. However, if the commodity price is now OTM when compared with the strike price there is a chance it might be abandoned.

The March 4, 2016 option expiry in euro forex futures provided an interesting example (see “Double whammy,” right). This is like a Zombie apocalypse. The futures closed right on the strike at 1.1000 (Bar marked “A”) at 3 p.m. EST. During the next hour the euro fluctuated above and below 1.1000. By 3 p.m. notification time, the 1.1000 call was ITM. Since the price closed at 1.1000 at 3 p.m. neither the call nor put on this strike would be automatically exercised. Any exercises would have to be Ghost Exercises and the option owner would have to go to the trouble of informing the exchange. One easy trade is for the call owner to contrary exercise and then sell the futures. This will lock in a guaranteed profit since the futures were sold in the 1.1005 range and the call option exercised would put the owner long the futures at 1.1000. The trade would be flat with a 0.0005 point profit, $62.50 per contract.

It is possible that owners of the puts also are contrary exercised. This creates the scenario whereby a trader who had sold the 1.1000 straddle could get ghost exercised on both the put and the call, or at least some of them.

The futures continued to stay above the 1.1000 strike on Friday evening. Then Sunday it gapped down below the strike and stayed there throughout the session.

Options are unique derivative products that give buyers the ability to limit risk while at the same time allowing them unlimited profit potential. On the other side of the trade are the option sellers. Much like an insurance company the option writers sell safety and buy risk. Some refer to this as selling volatility. Therefore there is a risk premium for the option seller.

At expiration options have zero time value. They also have zero volatility. The option will have a delta of either 1 or 0 because the option is either ITM with a delta of 100% or OTM and worthless.

Hard & soft closes

Some markets, like coffee and sugar have hard closes. This means that no trading is done after a certain time. In the case of coffee that’s 1:30 p.m. EST. For sugar it’s 1:00 p.m. EST. These markets don’t start trading again until the next morning at 3:30 a.m. EST for sugar and 4:15 a.m. EST for coffee. Because these are hard closes, the occurrence of Zombie options is far less likely. Other markets like crude, the Japanese yen and U.S Treasury bonds, E-mini S&P 500s continue to trade after the options market has closed. These markets have soft closes. Usually the option expiry time is based upon the traditional pit time.

About the Author

Robb Ross runs White Indian Trading Co., and developed its Stairs trading program (see "Ross: White Indian and rubber chickens," August 2010). He is an experienced programmer and system developer, having worked at both Microsoft and NASA.