Understanding on closing an option

Question

I have read that there are three scenarios when it comes to closing an option:

1. You can buy or sell to “close” the position prior to expiration.

2. The options expire out-of-the-money and worthless, so you do nothing.

3. The options expire in-the-money, usually resulting in a trade of the underlying stock if the option is exercised.

I understand 2 and 3 but have a question about #1. When I buy a call option for example, I am buying from someone who is selling/writing the contract. Similarly, when I sell to "close" a contract, someone has to buy the contract from me.

I read that from Robinhood that if the contract is about to expire and is out of the money, they will automatically sell it back in the market so I don't lose all of it. However, here comes my question, if my contract is about to expire in an hour, who would and why would someone goes and buys my contract which probably does not worth very much? And if that person decides to exercise that contract, wouldn't it just be cheaper to buy the 100 shares directly? Am I understanding this correctly? Thanks!

Answer 1

The statement by Robinhood that "if the contract is about to expire and is out of the money, they will automatically sell it back in the market so I don't lose all of it" makes no sense at all. Only the owner of the long contract can make the decision to sell or exercise the long contract prior to expiration (ignoring an auto-liquidation event by your broker because you got yourself into margin difficulty).

Yes, you are correct. No one would exercise an OTM long call in order to pay more for the shares when they could be purchased for less on the open market.

The only time that there is automatic exercise is when an option expires ITM. This is called Exercise By Exception and the Options Clearing Corporation (U.S.) automatically exercises any option that ITM by 1 cent or more. You have the right to designate to your broker that they do not to exercise such an option and allow them to expire. The reason for doing this would be that it would make no sense to pay a larger commission to salvage $1 or $2 (unless your broker provides free assignment and exercise).