Why Some In-The-Money Strikes Are NOT Exercised; A Real Life Example

When studying the basics of option investing we learn that the option holder of an in-the-money strike has a certain amount of intrinsic value which appears to be profit that would never be bypassed. For example, if we (as covered call writers) sold a $50 call and the stock was trading @ $52 @ 4PM EST on expiration Friday, the holder can exercise the option and buy our shares for $50 and sell for a profit after the market opens the following week. In addition, the Options Clearing Corporation has provisions for the automatic exercise of in-the-money options at expiration, called exercise by exception. Exercise will occur automatically if the strike is $0.01 or more in-the-money. Some brokerages may not have the same threshold as the OCC but $0.01 is very common. We, as call sellers, have no control over exercise. That is up to the holder. Why then are some of our in-the-money calls not exercised?

During and after hours trading

For Blue Collar Investors like us the ability to trade ends @ 4PM EST and most options expire on the third Friday of the month (technically the Saturday after the third Friday but we cannot trade on Saturday). However, professional traders have the ability to trade for 90 minutes more, until 5:30 PM EST. Now the options-related trading is based on the composite or consolidated price based on the 4PM price of the underlying security. The trader in this instance has until 5:30 PM to let the OCC know if he wants his options exercised. Those in-the-money options will be automatically exercised unless the trader provides a contrary exercise notice (“do not exercise”) to the OC in which case these options will not be exercised. For more information on after-hours trading see pages 430-432 of  Alan Ellman’s Encyclopedia for Covered Call Writing.

Real life example

• Purchase ALXA @ $5.30

• Sell a 1-month $5.50 call @ $0.95

• At 4PM expiration Friday ALXA was trading @ $5.79, the strike $0.29 in-the-money

• Exercise of option and sale of the shares @ $5.50 was anticipated

• The option was NOT exercised and the shares were NOT sold

• ALXA opened @ $5.18 on Monday morning after expiration Friday

• Several days later the stock was trading @ $4.82

The chart below shows the gap-down from expiration Friday to the following Monday:

ALXA gaps down

What caused this unusual circumstance?

When this BCI member first told me about this trade, the first thought I had was why was the initial 1-month return so high?

$95/$530 = 18%

Obviously the implied volatility of the option was high so I started my research. It turns out there was an FDA approval/disapproval result due out prior to expiration. The results were divulged 10 minutes prior to 4PM on expiration Friday. Although the initial results appeared positive (the company received approval), the professionals had 90 minutes to decide if they wanted to take possession of the shares @ $5.50. As they studied the details of the ruling many decided not to. 47% of those holding the $5.50 calls sent contrary exercise notices to the OCC and those in-the-money calls expired without exercise. On Monday, the market agreed and the shares continued to fall.

Lessons learned

The first lesson is to avoid stocks with extremely high implied volatility. I will rarely select an underlying that generates more than 6-7% for a 1-month return for at-the-money strikes. The second lesson is that if you do find yourself in that position close the short call and perhaps the entire position prior to the event in question.

Conclusion

Although in-the-money calls are almost always exercised after 4PM EST on expiration Friday there are exceptions. These unusual circumstances occur when professional traders make after hour decisions to send contrary exercise notices to the OCC because an event near or just after market close made ownership of the underlying undesirable in their eyes.

Thanks to ALL our members and my fabulous team:

We value all our members both general and premium. 2012 was a banner year for The Blue Collar Investor as our membership had its best year ever and continues to grow at a rate we never dreamed possible. We will never take this for granted and always work as hard as we can to justify the trust and confidence you have gifted to us. I also  want to thank the entire BCI team for a job well done and a special thank you to Barry for overseeing that our weekly stock reports maintain the highest possible level of excellence. I can’t possibly do all this by myself.

Market tone:

We had a successful roller-coaster ride through the fiscal cliff (hanger) and now have the debt ceiling (potential) crisis on deck. 2013 should be a great year for investors as long as our representatives do the right thing by negotiating in good faith and compromising so as many of us as possible get properly represented. This week’s reports generally support a bullish outlook:

• Payrolls rose slightly in December, up by 155,000 (150,000 was expected)
• The unemployment rate remained @ 7.8%  down from the 9.3% rate of 2 years ago according to the US Department of Labor
• For the 3rd consecutive month government jobs declined, this time by 13,000 in December
• For the first time in 8 months construction spending declined by 0.3% partly due to Hurricane Sandy
• The ISM survey of manufactures showed a modest improvement to 50.7 slightly better than the 50.0 anticipated (50 indicates expansion)
• Initial jobless claims (a report of the number of individuals who filed for unemployment insurance for the first time the prior week. While the weekly figure indicates trends in the job market, the four-week moving average is considered a truer gauge) for the week ending December 29th was at 372,000, worse than the 355,000 expected
• The ISM’s December nonmanufacturing survey climbed to 56.1 from 54.7 in November (54.8 expected)
• The FOMC (The 12-member FOMC meets to determine the near-term direction of monetary policy—in other words, to decide the level of short-term interest rates. Seven of the 12 members are members of the Federal Reserve Board appointed by the President. Four members are presidents of the regional Federal Reserve banks, who serve on a rotating basis. The president of the Federal Reserve Bank of New York is a permanent member) announced that it would link monetary easing to levels of unemployment and inflation rather than to specific dates so as to provide greater transparency

For the week, the S&P 500 rose by 4.6% as the New Year got off to a positive start.

Summary:

IBD: Market in a confirmed uptrend

BCI: Long-term bullish and short-term cautious. Returning to a fully-invested position but favoring in-the-money strikes.

My best to all,

Alan([email protected])

www.thebluecollarinvestor.com