We got a great subscriber question on trade management the other day that I wanted to turn into an educational post for all to see. Here is the question.
When holding a fly into expiration, with the underlying price right at the short strike (max gain) how do you manage the close of this trade?
For example, I had a May 92.5/95/97.5 call fly on CME with the short strike at 95. The stock appeared to be pinned at 95 for the better part of the afternoon, and I had limit orders in at various prices to try to close the structure in one trade. As the closing bell approached, the stock sat literally at 94.9x, but the order for the full fly was not getting hit with a limit as low as in the range of 2.30.
I finally exited the trade in two steps – closing out the lower leg as a vertical, and although I tried closing out the upper leg also as a vertical, with the stock sitting at 94.99 I was not comfortable taking the risk of getting caught short 95 calls, so I had to buy those back for 0.12 a few mins before the close.
I get that the max gain is theoretical in nature, and that depending upon liquidity of the options I’m going to have to compromise on closing price vs. risk. I could have taken the chance and let that upper leg expire worthless, but I was surprised at the premium on those 95’s even with just minutes to go into the close.
In situations such as this, is there a best practice in terms of strategy to exit the trade, or is every situation different? Am I correct in concluding that the trade was illiquid enough to cost me some of that potential max gain to exit the trade?
There are two existing risks that we’re talking about here. The first is execution and the second is expiration risk. Both have to do with the nature of pin risk. Pin risk by definition is when a stock expires (or is about to) at the strike of a trade you are short. The risk is the uncertainty of whether the stock will expire just above or just below that strike. Adding to the uncertainty is even if the stock close just on the worthless side for your short option you may still be assigned buy the owner of that option for various reasons, but most likely that that owner needs those deltas to keep a position and is willing to give up the 10-15 cents so that they don’t walk in Monday off sides on deltas.
Usually, the best way to handle that risk is to trade out of the position entirely before the closing bell on expiration to avoid the dilemma entirely. But on a multi legged trade like the one in the question, that’s often easier said than done.
He is correct that liquidity is a factor in not being able to close the short 95 calls. That’s stock specific as things are very different if it was 10 minutes to expiration in SPY options vs. CME where CME will simply have wider bid/asks on its options. But the largest factor here, again, is that pin risk. If you’re trying to close your short 95 calls just before expiration with the stock hovering at that same price, the market makers will need a premium above and beyond the normal distribution of intrinsic/extrinsic value on options that were not at risk of the ambiguity of being pinned at the moment of expiration. They’re essentially saying:
“fine, I’ll take over your pin risk and deal with it, but it will cost you.”
The best recommendation I can give is to go fishing for an execution on the entire trade (no need to trade the 97.5 call portion, so it’s basically a 1×2 you are trying to get filled on) while walking your price down a little at a time in those 15-20 minutes before expiration. The reader did essentially the same thing but had to separate the last short call on its own, and that’s fine too.