Managing your hedges around options expiration

by Wayne Ferbert on December 19th, 2011

Last Friday was the monthly options expiration. And if you have been following this blog, you know that the cost to hedge in the broader markets has been declining slowly. The lower cost to hedge makes this a good time to be rolling hedges forward if you had expiring positions. This decline in the cost to hedge corresponds to the decrease in volatility. Volatility determines the ‘time value’ cost in an option. And the time value cost is your premium you pay to be hedged.

Of course, volatility also determines the premium you collect when you ‘sell away’ or limit your upside in a position. The higher the volatility, the higher premium you collect to do this. And you know we use that premium collected to offset the cost to hedge. (I know this seems basic – but stick with me as the lessons to learn here are very practical).

And if you have been reading this blog, then you know that the cost to build downside protection has been MORE expensive that the premium you collect when you limit your upside. This kind of skew in the time value premiums is evident when the market is more pessimistic than optimistic. It means the market thinks a decline is more likely than a market increase.

But that skew has been changing a little bit in the last week. As volatility has come down, the skew has also started to balance out. The premiums you can collect on broad market indexes for selling away some of your upside has started to increase in comparison to the downside protection. This could mean the market is getting a little more optimistic. We’ll see. But one way or the other, you should be collecting more premium to offset the cost of hedging if you use collars or spreads to build your hedged positions.

Now, with this context in mind, let’s talk about rolling your hedges at expiration. Because even with all of this context about time value, the market can behave in a funny way around expiration. The time premium on the last 2 days before expiration can often be a little odd – meaning the bid/ask spreads get very wide. And this is true not only on the options expiring but also on forward month options. And this oddity can persist on the forward month options for the first 1-2 days after expiration.

The market makers and the professional options traders know that a lot of options investors are looking to roll positions prior to expiration to avoid the capital requirements of assignment or exercise. And many options investors are looking to re-create positions right after expiration – whether to roll over a position that was assigned or expired worthless. So, sometimes around expiration, the bid/ask spread widens more than usual – putting the individual investor at a disadvantage.

My advice to you: don’t be afraid to allow your ITM options to get exercised or get assigned to you at expiration. And then wade back in to the market on the Monday or Tuesday when the water looks warm again (ie, when the premiums and the bid/ask spreads look normal to you again). It will create another commission in your account because you will be charged for the assignment/exercise. And then you’ll need to sell/buy that stock and then buy/sell the option you want to re-create your position again. But don’t be afraid to let that happen – especially if the bid/ask spread doesn’t look fair to you and it doesn’t look like you are paying or collecting the right premium. I even recommend this strategy if the exercise/assignment might require a temporary margin position to fund it. The cost of margin for a couple of days should be less than the value you are unable to find in your options contracts.

So, that’s what happens with respect to assignment/exercise, but what about put options that make up the protection in either a collar or a bull put spread. What if they expire out of the money on Friday? And now without those positions, you are not hedged. And you face going in to a weekend without being hedged? IN other words, you might violate rule #1 of Buy And Hedge: Hedge Every Investment.

Despite the fact that this breaks Iron Rule #1, the advice is the same. If the bid/ask spread doesn’t look fair (given your experience in buying/selling the time premium in this position in the past), then go ahead and let those puts expire worthless. It means temporarily being un-hedged in some of your positions for the weaken. On Monday or Tuesday, look to wade back in to the options market when the bid/ask spreads start to look more normal.

There is one caveat to this rule. We presume that you don’t have EVERY hedge for every position in your portfolio expiring on the same Friday. You can’t have all of your portfolio protection expire on the same day and go in to the weekend with no protection at all. This advice presumes that you either have (a) laddered your put protections to expire at different months; or (b) your different underlying put positions expire at different months.

Two more options expiration tactics to look out for: (1) rolling In-the-Money (ITM) covered calls and (2) knowing your ex-dividend dates. First up: if you have a collar, you don’t want to unintentionally create a taxable event on your underlying stock/ETF. One of the advantages of the collar strategy is the ability to hold the stock/ETF for over a year and make sure the gain would be treated as a long-term capital gain. If the covered call you sold ends up in-the-money and it is about to expire, it will get assigned and you will have to deliver the stock you already own. If the sale is going to create a gain, you will end up taxed on it. If that is your situation, make sure to roll the covered call by buying it back prior to expiration – and consider rolling it forward to a new value in a forward month.

The second tactic to consider comes when you use spreads. Spreads will typically have ITM positions that you either own or sold. These can lead to exercise or assignment which means you will own the stock upon expiration. Check the next expected ex-dividend date for the stock. You will usually find the ex-dividend date is always the same as the Friday options expiration date. You may want to own the stock thru the next options expiration to collect a dividend. You need to compare the dividend amount to the premiums in the call/puts you intend to buy or sell. Much of the dividend value may already be represented in the price of the put or call. But you need to compare it. I know that I often end up holding the stock/ETF once every 3 months if the stock pays its dividend quarterly.

Let’s look at an example. Let’s say you like to use bull put spreads and you sell the near month ITM put to keep generating time premium. And you also own a forward month (maybe 3-6 months out) put that is out of the money that represents the other end of the put spread. So, every month you usually get assigned and end up owning the stock. If the next ex-dividend date is NEXT MONTH’s options expiration, you may want to keep the stock through that date to collect the dividend. You would just compare the expected dividend amount to the time premium quoted in the next month’s ITM put you would usually sell. Most of the time, some but not all of that dividend is reflected in a spike in the time premium in that quote. Let the comparison of the two guide your decision. Remember that you still want time premium on top of the expected discounted dividend amount. Compare it to what you could collect for selling the call on the underlying stock you now own.

These techniques need to be considered by the smart Buy and Hedge investor. And these techniques can save you a lot of money around expiration – and help you squeeze more return out of your portfolio!

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