Most option traders don't want to actually buy or sell the underlying stock. They just use options as a trading vehicle perhaps making money on the time decay, on changes to volatility, etc. My question is, if most traders are motivated to sell or buy to close their option contracts before the expiration date, who's actually holding the contracts at the end of their life? Do brokerages or exchanges sort of let those pile up and balance each other out or what?
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1"Most option traders don't want to actually buy or sell the underlying stock." Umm...No...That is just complete nonsense. The Cash desk is an integral part of every Volatility desk.– AronNov 1, 2016 at 3:23
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1I was told differently, so perhaps I could restate the question as "Why does it work out at the end of every month that anyone who wants to close (either sell to close or buy to close) their option position can. Why doesn't my brokerage ever say "sorry, we don't want to buy/sell that position to close because nobody else wants that contract... you're stuck with it"?– Jeremy FosterNov 1, 2016 at 14:31
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Perhaps the issue here is that you have a different notion of "options trader". For me, its someone who buys and sells options (perhaps even synthesizing an option to sell). For you, it sounds like "options trader" = "investor in options". Exchange traded options usually have a bank as a "market maker". The market maker is obliged to buy all options offered to it, and it is obliged to sell the option as long as there are units left to sell.– AronNov 2, 2016 at 1:03
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Per the OCC, in 2017, 93% of ALL option contracts were closed before expiration. All of the nonsense mentioned about what trading desks do is a small subset within those numbers. Also, the broker cannot say "Sorry, we don't want to buy/sell that position to close because nobody else wants that contract... you're stuck with it". There's always a market for the option. You just might not like the prices available (wide spreads, high/low IV).– Bob BaerkerOct 22, 2018 at 21:55
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@BobBaerker No matter what, an ITM option will be worth more being sold back to the market maker than exercising. Regulators require banks to publish our pricing observables for our models, which we price our bid/ask (we may mark these observables to maximize profits). Therefore we MUST pay you for the time value left on the option, on top of the intrinsic value.– AronOct 23, 2018 at 4:17
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4 Answers
Options that are not worth exercising just expire. Options that are worth exercising are typically exercised automatically as they expire, resulting in a transfer of stock between the entity that issued the option and the entity that holds it. OCC options automatically exercise when they expire if the value of the option exceeds the transaction cost for the stock transfer (1/4 point to 3/4 point depending).
answered Oct 31, 2016 at 19:14
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5Exactly. As the name implies, exercising an option is optional. If it isn't worth taking advantage of, it just gets ignored. The buyer purchased the right to make that late decision, not an obligation to do so. (On the other hand, the purchase doesn't get refunded just because they chose not to exercise it.)– keshlamOct 31, 2016 at 20:03
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1Sounds all true, but that's not the question. I do understand what happens when an option expires, but I was under the impression (based on a conversation with someone more knowledgeable than I am) that a majority of traders want to offload options before they expire so I was wondering why there's not a backpressure to closing options positions. Nov 1, 2016 at 13:03
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@JeremyFoster I don't understand what you mean by "backpressure". Nov 1, 2016 at 20:05
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@JeremyFoster The options you are likely to trade as a private investor are likely to be an asset class which is exchanged on the Stock Exchange (as opposed to the Futures Exchange). These are provided by a large bank, which undertakes obligations to ensure that investors can close out positions whenever they want. Here is an example of such a contract hkexnews.hk/listedco/listconews/sehk/2016/1020/… refer to the section on Liquidity Provider.– AronNov 3, 2016 at 5:24
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Owners want to offload their options before they expire for several reasons. One, hopefully they're profitable. Two, unless your broker provides free assignment and exercise, there are fewer commissions by selling to close an option versus exercising it and then having to close the underlying position. Third, exercising an option that has time premium remaining throws away that time premium if it exceeds closing commission costs. Oct 22, 2018 at 21:49
Firstly "Most option traders don't want to actually buy or sell the underlying stock."
THIS IS COMPLETELY UTTERLY FALSE
Perhaps the problem is that you are only familiar with the BUY side of options trading.
On the sell side of options trading, an options desk engages in DELTA HEDGING. When we sell an option to a client. We will also buy an appropriate amount of underlying to match the delta position of the option.
During the life time of the option. We will readjust our hedge position whenever the delta changes (those who follow Black Scholes will know that normally that comes from (underlying) price changes).
However, we lose money on each underlying change (we have to cross the bid-ask spread for each trade). That is why we lose money when there is volatility. That is why we are said to be "short VEGA" or "short volatility".
So one way to think about "buying" options, is that you are paying someone to execute a specific trading strategy.
In general, those who sell options, are also happy to buy options back (at a discount of course, so we make a profit). But when doing so, we need to unroll our hedging position, and that again incurs a cost (to us, the bank).
Finally. Since this is "money" stackexchange rather than finance. You are most likely referring to "warrants" rather than "options", which are listed on stock exchanges. The exchange in most regions give us very specific and restrictive regulations that we must abide by. One very common one is that we MUST always list a price which we are willing to buy the warrants back at (which may not be an unreasonable spread from the sell price).
Since an Option is a synthetically created investment instrument, when we buy back the Option from the investor, we simply unwind the underlying hedging positions that we booked to synthesize the Options with.
Source: I've worked 2 years on a warrant desk, as a desk developer.
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Thanks, @Aron. I'm new to money.stackexchange.com. I don't know what you mean by "rather than finance". I hope I'm not in the wrong forum to be asking this question. I am referring to options traded on stock exchanges though and I don't know what warrants are. I was told that "most traders don't want to actually buy or sell the underlying". You answered how options contracts are sold and bought, but I think I understand that. My only question is around why it works out every month that everyone who what's to close their options position can do so. Nov 1, 2016 at 14:27
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@JeremyFoster My point was that given you are using "money" you are likely a private investor, rather than working in IBanking for example. In my market, stock exchange traded options are called warrants (whereas true options are traded on a derivative exchange or OTC). In warrant trading, we banks are the market maker, which means that we MUST buy any and all warrants that are offered to us (that is one of the conditions of us listing on the stock exchange). We always want to close your position, because delta hedging is a risky business.– AronNov 2, 2016 at 1:00
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1The OP asked whether option traders want to own the stock. The answer to that is mostly NO and the proof is that as per the OCC, only 7% of all options were exercised. That means that 93% of them expired or were closed before expiration. Describing how market makers and trading desks delta neutral hedge their positions is a smaller part of the market. Many traders are doing just that, trading options. Oct 22, 2018 at 21:45
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@BobBaerker maybe we have very different notions of "trader". Additional exotic desk traders will use options for Gamma hedging and trade the underlying for delta hedging. Options and Cash trades aren't mutually exclusive. Lack of understanding of the risk profiles leads to many retail consumers losing vast quantities of money.– AronOct 23, 2018 at 0:52
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2To repeat, 93% of options are closed before expiration or they expire worthless. Only 7% are exercised. That is proof positive that option owners "don't want to actually buy or sell the underlying stock." It's specious to imply that 100% of those short on the other side of the OI are "exotic desk traders" gamma and delta hedging. They are in the minority from the get go and more so because many retail customers are on the short side as well. Oct 23, 2018 at 1:52
To answer your follow up questions, the fundamentals of option trading means that there will always be a balance in options. Every time one party sells a contract, there is a buying party on the other end. A party might be trading to open, or trading to close the position.
When both parties are trading to open, an option is added to the 'open interest' pool. When both parties trade to close, it removes one from the pool. When one opens and the other closes, the open interest number remains the same, but the option was essentially transferred from the closing party to the opening one. Thus every option represents a match of two parties with open positions in the underlying contract.
After reaching their expiration date, all options are either executed or expire worthless. As each option represents a match between two parties, each contract has someone to execute on.
Complications only arise if one of the parties is unable to fulfil the option contract, for which there are margin limit requirements and margin call actions that the broker might resort to in order to not be on the hook for the executing contract.
I interpret the question as asking why there is a liquid market in options, so that any one trader can buy or sell when desired. This is similar to the reasons for liquid markets in other instruments: a combination of arbitrage and elastic supply/demand. (These are the fundamental reasons, but in addition market makers are tasked with helping maintain liquidity through short-term disruptions.)
If you are offering a particular option at a low enough price, or bidding for it at a high enough price (relative to other options and the underlying), then even if no one would otherwise be interested in taking the other side of that order, self-interested traders will step in when a risk-free arbitrage is possible. So you can usually close your position for something close to fair value.
If your demand isn't subject to direct arbitrage (e.g., if you're making a straddle bet on volatility with both puts and calls), you can still get your trade done with someone who thinks volatility will be higher or lower than your offer or bid implies. This is much like the trading of ordinary stocks, where a seller can pretty much always find buyers by offering at a low price, or vice versa by bidding at a high price. As the price falls, previously reluctant buyers come out of the woodwork (elastic demand), and vice versa. It's a big market, and you just have to adjust the price enough to shift the global balance of supply and demand by your few contracts.
That said, options are typically less liquid than their underlying stocks, and options with very low fair value may have no bids.
