Even the most experienced option traders trying out a new strategy or underlying will occasionally miss some simple thing about their trades. Let's talk about a few of those simple things.
The simplest and most basic understanding you must have when trading options is what exactly is your underlying? Many people stumped by the behavior of their VIX options soon find out why. VIX options aren't pegged to the current price of the VIX but rather to VIX futures. They're watching the wrong underlying. This peculiarity is the reason that I don't tend to trade VIX options and don't recommend that anyone else does, either, unless they're experienced enough to understand all their peculiarities. Even if you're using them to hedge another position, they might not hedge as well as you expect them to do.
Do you know the last trading day of your option? While we're on the topic of the VIX, it's important to point out that some underlyings have non-standard expirations and last trading days. The CBOE's product page on the VIX verifies that the last trading day for VIX options is "the Tuesday prior to the Expiration Date of each month," with that expiration date the "Wednesday that is thirty days prior to the third Friday of the calendar month immediately following the expiring month." That non-standard last trading day and expiration catch even some experienced traders by surprise.
If you've sold a call as part of a spread such as a call debit spread and that call is in the money, with little extrinsic value, can it be exercised? Not if it's a VIX call. Those are European settlement, which means that it can be exercised only on the expiration date. However, if you've sold a Lennar call that's now deep in the money without much extrinsic value, you might find one fine morning when you open your email that you've been notified that the call has been exercised.
What happens if you have an HD or SPX call that's in the money on the last day of trading? Different things, and you'd better be aware of the differences. Unless you close out that HD call or contact your trading platform to alert them that you don't want it exercised for some reason, it will be automatically exercised if HD is above the strike price by the cutoff amount your platform uses. The email you get this time informs you that you are now the owner of HD stock and you'll be asked to pay for it. Don't panic if you don't have enough money in your account to pay for the stock. Since the settlement time is three days for the stock, you have the opportunity to sell that stock if you didn't intend to own it, but you'll incur transaction costs and risk slippage from price movement, too.
The SPX is different. It's cash-settled. If the SPX is above the strike price of the long call you own on its last trading day . . . . you don't have a clue what will happen next. Settlement values for the SPX are determined the next morning, based upon the opening price for each component of the SPX, and not upon the opening price of the SPX. You can have a settlement price well above or below any price the SPX hit that day. Believe me. I've seen settlement prices 20 points off the Thursday closing price, at a price never traded during that Friday.
You can end the last day of trading for that option thinking you're going to collect some cash and find out that you've got nothing coming to you after all. Or, if you're lucky, a whole lot more coming to you than you expected. This is a risk with the SPX and some other cash-settled indices such as the RUT. The OEX options trade on Friday of opex week, and settlement value is based on the last value of all OEX component stocks, so you don't have the same overnight risk on this particular cash-settled index.
Oops. But the OEX options are not European-style options. This is one option that's cash-settled but is American style, and they can be exercised at all times. If you want an OEX-based trade but don't want to have that exercise risk on your complex trades, you'll have to move to another OEX-based option, the XEO. I have heard stories of people having an unexpected and disastrous exercise of a sold OEX call that was part of a complex trade, but I think I've known it to happen to only one person in all my years of trading. The stories and warnings are more prevalent than the actual cases, in my opinion.
Still, I'm a cautious sort, and I used to employ XEO options in some of trades rather than OEX ones. I don't know that the liquidity is the same as it used to be, so that might not even be a viable choice any longer.
As should be clear, the simplest thing about options trading can surprise you. We haven't even talked about the way that some ETF's such as the VXX tend to be repriced in ways you (and I) may not quite understand. Your option trade on such a vehicle may not behave as expected because the underlying may not behave as expected.
Being sure you understand these simple things about options trades is a must. Even experienced options traders get caught sometimes, forgetting to do their homework. You won't be alone if you've goofed. Try to keep the goofs to a minimum, however, by doing your research--typically on a CBOE product page or the like--before hopping into an enticing trade.
Next week, we'll talk about some simple things to understand about the strategies themselves.