The Hidden Danger of Holding Option Spreads to Expiration
Many traders use defined-risk strategies like debit and credit spreads, believing their risk is limited. However, holding these spreads until expiration can expose traders to unexpected and significant losses. This article explains a little-known risk associated with spread trading and emphasizes the importance of closing positions before expiration.
The False Sense of Security with Spreads
The common understanding is that when holding a spread to expiration, one of two outcomes will occur:
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Assignment and Exercise: If the short leg is in the money, it's assigned, and the long leg is automatically exercised, offsetting the assignment. The result is either a gain (debit spread) or a loss (credit spread) equal to the width of the strikes.
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Expiration Out of the Money: A debit spread expires worthless, and a credit spread allows you to keep the premium.
However, a third, much more dangerous scenario can unfold.
The Third, Devastating Scenario: After-Hours Reversal
This scenario occurs when the short leg expires in the money, and the counterparty's brokerage begins the exercise process. To protect you from assignment, your long leg also begins the exercise process. However, after hours, the underlying asset price can move dramatically, pushing the short leg out of the money.
At this point, the counterparty can cancel their exercise. However, your long leg's exercise may already be in progress and cannot be cancelled, leaving you holding a potentially massive, unhedged position over the weekend.
Imagine this scenario: You have a call option that exercised and you are now holding 100 shares of the underlying stock. If the stock price moves against your position over the weekend, you could face substantial losses, potentially wiping out your savings.
The Brokerage's Lack of Warning
Alarmingly, brokerages typically don't warn traders about this potential risk. Many traders focus on pattern day trading rules, overlooking this far more significant threat to their capital.
The Solution: Avoid Expiration at All Costs
The only way to completely avoid this risk is simple: do not hold spreads into expiration. The potential benefit of holding until the last minute is minimal, often just a few pennies of premium. This small potential gain is not worth the risk of a catastrophic loss.
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With a debit spread, you're risking the entire premium paid.
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With a credit spread, you're only hoping to gain a few extra pennies.
Instead, close your spread positions before expiration. Buy to close the positions and eliminate the risk of after-hours movements.
Share This Information
This information is crucial for all spread traders. Please share this article with other traders to prevent them from experiencing devastating losses. No one wants to wake up to a massive margin call due to a defined-risk strategy gone wrong. Protect yourself and your fellow traders by spreading awareness.
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