The selection and management of a vertical spread for a stock
investment option are only two-thirds of the game. Closing out,
rolling or morphing the position has to be analyzed and executed
with the same due diligence as was used in the selection and
Looking at the closing out of a vertical call spread for a stock
investment option, we find there are three possible outcomes
that must be addressed. The stock investment option spread can
finish out-of-the-money and valueless. For a call spread, this
scenario occurs when the stock investment option closes at or
below the lower strike of the spread. In this scenario, in order
to close out the stock investment option
spread, one would just
let it expire. Both options finish out of the money so no residual
position will be left over.
If the stock investment option spread finishes fully in the
money, (at maximum value) that is with both options in-the-money,
then both options will be exercised. You will exercise your
long call and your short call will be assigned. They will cancel
each other out and you will be left with no residual position.
This scenario occurs when the stock investment option price
closes lower than the lower strike call involved in the spread.
The difficult scenario is when the stock investment option closes
in between the two strikes of the spread. This scenario, the
closing of the stock investment option between the two strikes
creates a situation where one strike winds up being in-the-money
while the other ends up out-of-the-money.
When both options expire in-the-money, they are both exercised-one
creating a long stock option, the other creating a short position
thus canceling each other out. This is not the case here. Here,
one stock investment option, the one that is in-the-money will
leave a residual stock position and since the other option is
out-of-the-money, it will not be able to be used to offset the
residual stock position created by the expiring in-the-money
stock investment option
There are two actions that could be taken. Choice number one
involves trading out of the stock investment option on expiration
Friday just before the close. Because of the bid/ask spread
of the two options, you will probably have to give away some
of your profits in order to close out the position.
Giving up a portion of the profits may be the best thing to
do in order to avoid naked, unlimited risk.
If you only trade out of the in-the-money option, you run the
risk (albeit short-lived because you are doing this late on
expiration day of the expiring month) that the stock investment
option moves adversely and the out-of-the-money option suddenly
becomes in-the-money. If that happens, you will now be naked
the residual stock position. Of course, if there is still time,
you could always trade out of the stock investment option then
but that is very risky. However, if the stock investment option
is at a relatively safe distance from the out-of-the-money you
may want to just close out the in-the-money option and let the
out-of-the money option expire worthless.
The two factors that must be considered are: the combination
of the distance of the strike from the stock investment option
price in relation to the short amount of time for the stock
to get there, and the amount of money saved by not buying back
the out-of-the-money stock investment option. Remember, this
is being done at the very end of the day on expiration day.
These options only have minutes of life left. So, knowing this,
the risk is somewhat mitigated, but still there none the less.
The catch is the proximity of the stock investment option to
the out-of-the-money option. If the stock is close to the out-of-the-money
option, you would be best advised to trade out of the spread
Again, as stated before, if the stock investment option closes
either with the spread fully in-the-money, or fully out-of-the-money,
the position will adjust itself through the exercise process
leaving no residual position. If the stock investment option
price finishes between the two strikes, there will be a residual
position. We discussed above how to trade out of this position.
Your second choice is not to trade out and allow yourself to
go through the expiration process. You must remember that if
you are going to accept a residual stock position, you must
be able to afford it.
Then, if you have 10 July 50 calls and you exercise them you
will be receiving 1000 shares of stock at $50.00 per share.
Thus, you must have $50,000.00 of cash and/or margin in your
account to receive the stock. If you do not have enough cash
and/or margin to accept delivery of the stock investment option
then you must trade out of the position before it expires.