When you open an option position, you have two choices: Buy it or sell it. The actual orders used would rather be ‘buy to open’ or ‘sell to open’. Once you are long or short of an option, there are a number of things you can do to close the position:
- Close it with an offsetting trade
- Let it expire worthless on expiration day or,
- If you are long an option, you can exercise it and if you are short, you may experience the other side of the exercise i.e. being assigned.
Before we begin, it is important to note that most of the stock options trading on all the US exchanges are American-style options. They differ from European-style options in that they can be exercised any time, until the expiration. On the contrary, European-style options can be exercised only on the day they expire (although they can still be bought and sold at any time prior to that).
- Offsetting the option: Square off (or closeout)
Offsetting is the primary way, by which, most traders close a position. Offsetting is simply a method of reversing your original transaction to exit the trade. You can always sell an option that you previously bought, or buy an option that you previously sold, at any time before the end of the last trading day. For example, CNX Nifty options contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day.
If you own (bought) a call, you have to ‘sell to close’ exactly the same call (with the same strike price and expiration) to close your position. If you are short (sold) a call, you have to ‘buy to close’ the same exact call to close your position. If you own a put, you have to ‘sell to close’ exactly the same put. And if you sold a put, you have to ‘buy to close’ the put with the same strike price and expiration.
If you do not offset your position, then you have not officially exited the trade. If you are long a call and you sell another call (with a different strike price or expiration month), you may have reduced your risk but not closed your position. Instead, you would now have two positions (although you may think of it as a single combinational position). Doing an offsetting transaction is usually the best way to close out a position if there is still some time remaining for the expiration. The difference between the premiums at which you buy/sell the options will be your profit/loss.
- Exercising the option
You can only exercise an option if you are long (own) the option. If it is before the expiration date, you are almost always better off closing it with an offsetting transaction rather than exercising it. When you exercise an option, you give up any extrinsic value it may have. Only the intrinsic value will be realised – any time value remaining is lost.
When you exercise an option, you are actually buying or selling the underlying asset. Exercising an option would be appropriate in a situation where there is a little or no time value and you want to buy the underlying (in the case of a call) or sell the underlying (in the case of a put). By exercising an option you have purchased, you are choosing to take delivery of (call) or to sell (put) the underlying asset at the option's strike price.
In certain instances, an option may be auto-exercised by NSE Clearing Ltd (Clearing Corporation for NSE) or by Indian Clearing Corporation Ltd (ICCL) for BSE.
You can get assigned only if you are short of an option. You will receive a notice of assignment only if a person that owns the same option exercises it. You have no control over this; it is a decision that has to be made by the other party in the options contract (or when it is auto-exercised on expiration day). If your short option is in-the-money on expiration day, you are pretty much guaranteed to be assigned. If someone owns the same option, you are short chosen to exercise it early (before the expiration day), Clearing Corporation (semi) randomly assigns the exercise to someone that is short the same option. And it is always possible that will be you. However, it rarely makes sense to exercise early. So, it is unlikely that you will be assigned prior to the expiration day.
Once you are assigned, you must fulfill your obligation under the option contract. In the case of a call option, you would have to sell the underlying asset at the strike price to the call holder. In the case of a put option, you would have to buy the underlying asset at the strike price from the put holder. How do you meet your obligation in the assignment? It depends on whether the option was covered or naked.
- Letting the option expire
The final way you can close an option position is to let it expire. If an option has no value at expiration and it has not been offset or exercised, the option expires worthless and no further action is required. An option will expire worthless only on the expiration day, and only if the option is at or out-of-the-money (OTM) i.e. the strike price is higher than the underlying price for a call or lower than the underlying price for a put.
Letting your option expire worthlessly is really the only viable decision when it has no value, which will be the case for virtually all out-of-the-money options at the close of the last day of the trading. If you are long an OTM option, you will notice that there is usually no bid price being quoted, since no one wants to buy a worthless option. If you long (own) an option that expires worthless, you lose all the money you have invested in the option.
Of course, this outcome is exactly what the option sellers are hoping for. If you are short (sold) an option, then you want it to expire worthless because then, you get to keep the credit you received from the option premium. You can almost always offset a short option up to the very end of trading. There is almost always an ‘asked price quoted’ because a lot of people would like to sell you a worthless option.
Before entering any option position, you should understand all the possible ways to close the position. When you are the owner of an option, you can close it by doing an offsetting (sell to close) transaction, exercise it, or let it expire worthless. Option sellers can only choose to do an offsetting transaction (buy to close) or let it expire worthlessly, and there is always a possibility that they may get assigned.