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I just answered a few questions on Robinhood and suddenly I am able to trade options without holding any stock of the underlying security. I assume there are a lot of people that have the same ability. This led me to the following thought:

From my understanding of Robinhood's options knowledge center, without the ability to exercise the option (i.e. I don't hold 100 shares nor have enough cash to buy 100), I cannot write contracts. Instead, I am only able to buy already written contracts, and I can only sell my contracts back to the market. In fact, Robinhood states that on expiration, the option will be "automatically sold back to the market a few hours before market close".

My understanding of such a sell transaction is that it would require 3 parties: myself, who owns the option; someone interested in purchasing a covered call; and someone interested in purchasing a covered put. This is the only way I imagine I can sell the option without still being obligated to the contract (Robinhood says my max loss is the premium I paid when I bought the option, so I cannot be obligated). My questions are as follows:

  1. Who in their right mind would buy and cover the out-of-money side of the option just a few hours before closing?
  2. Given question 1, what happens if there is not enough market activity to sell the option, could I be stuck with the option, having paid the premium, without the ability to exercise?
  3. Given question 2, if the open interest is 1 on the day of expiration, the option cannot be sold back to the market due to lack of interest, and I am on the out-of-money side--could it suddenly be assigned?
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From my understanding of Robinhood's options knowledge center, without the ability to exercise the option (i.e. I don't hold 100 shares nor have enough cash to buy 100), I cannot write contracts. Instead, I am only able to buy already written contracts, and I can only sell my contracts back to the market. In fact, Robinhood states that on expiration, the option will be "automatically sold back to the market a few hours before market close".

Small detail but the contract that you buy does not have to be 'already written'. The counter party may be selling to open (STO) when you buy to open (BTO).

In the US, if an option is one cent or more in-the-money (ITM) at expiration, the Option Clearing Corp (OCC) will automatically exercise options whether they are long or short. This is called Exercise by Exception. For equity options, you will end up with a long or short position in the underlying (index options are cash settled).

If you are long the option, you can designate to the OCC via your broker that it is not auto exercised at expiration. This would make sense if it is ITM by pennies and your commission and/or fees to close the position exceeds the ITM amount.

That is why Robinhood closes options a few hours before expiration. I think that it's an unfair practice if there's no notification because it can lead to undue investor risk - but that's another story.

My understanding of such a sell transaction is that it would require 3 parties: myself, who owns the option; someone interested in purchasing a covered call; and someone interested in purchasing a covered put. This is the only way I imagine I can sell the option without still being obligated to the contract (Robinhood says my max loss is the premium I paid when I bought the option, so I cannot be obligated).

There are two parties to the transaction (a buyer and a seller) not three. There are four possibilities, depending on who is opening or who is closing their position:

BTO + STO

BTO + STC

BTC + STO

BTC + STC

Let's start with some proper terminology.

Buying a put or a call means that you are long the option. You own it.

Selling a put or a call means that you are short the option.

A covered call means that you own the stock and you sold a call ( + S - C )

A covered put means that you are short the stock and you sold a put ( -S - P )

If you have the appropriate approval and the margin, you can sell a naked call or a naked put ( -C ) or ( -P ). If you don't have approval for naked writing but you have approval for cash secured short puts then you can sell the put ( Cash - P ).

Who in their right mind would buy and cover the out-of-money side of the option just a few hours before closing?

An extreme example: If a just out-of-the-money naked call is near worthless a few hours before expiration, a takeover is announced and the stock jumps $20, guess who loses a pile of money?

What happens if there is not enough market activity to sell the option, could I be stuck with the option, having paid the premium, without the ability to exercise? If the open interest is 1 on the day of expiration, the option cannot be sold back to the market due to lack of interest, and I am on the out-of-money side--could it suddenly be assigned?

A long ITM option can always be exercised if you have the margin to support the position. You don't so this doesn't apply to you. For those that do have it, sometimes, exercising an ITM option (with simultaneous closure of the newly acquired position in the underlying) provides a better sale price than selling it.

The market maker makes a market for all options. If an option has value, there will always be a bid and an ask. You may not like the price but it will exists and you'll be able to STC the position.

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  • This has really helped crystallize my thoughts. Thanks! But to clarify, because I am not covered, I think I can only STC on the sell side. Robinhood says my max loss is the premium I paid for the option. If it's $20 out-of-money when I STC and not covered, how does the other side of the contract make their $20*100=$2000? – jacob Mar 12 at 14:37
  • If you but a put or you buy a call, you own it (BTO). Covered refers to a combination position of ( S - C) or ( -S - P). To close a long option via sale, you STC. If your call is $20 OTM and expiration is near, it's going to be near worthless. You will be approaching a total loss of premium paid. Let's assume that the counter party who sold it to you originally stills has the position. He is approaching his maximum gain. He can either BTC or let it expire. $20*100=$2000 has no relevance to this situation. Do yourself a favor and read a good option book or two. It will help you immensely. – Bob Baerker Mar 12 at 14:46
  • Thanks for your time in answering my question. Do you have any book recommendations? – jacob Mar 12 at 21:46
  • Glad to be of assistance. AFAIC, the best overall option book is "Options as a Strategic Investment" by Lawrence G. McMillan. It's well written with many clear examples. If you want to save some bucks, pick up an inexpensive copy of an older edition online and down the raod when you're ready for the more complicated strategies spring for the latest edition. Hull, Taleb and Natenberg have also written good books but they are more geared to the complex as well as much deeper into theory. I think that McMillan's is far more useful for a retail investor/trader. – Bob Baerker Mar 12 at 21:51
  • @jacob depending on your option level, you can write contracts (sell to open) as long as doing do does not introduce undefined risk. – IVcrush Mar 12 at 22:29
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Something sounds very wrong here.

If an option is out-of-the-money, it would simply expire worthless.

If it is in the money, as holder, you have the right to exercise the option up until market close on the date of expiration.

Until the market closes, you have the right to exercise it or sell it back to the market, for which there may or may not be buyers depending on the price you are seeking. You should be able to get the quoted Bid price for it up until market close.

I do not think Robinhood can close it out from under you until the market closes; whether in the money or not.

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