Managing Expiry of In-The-Money Call Options: Understanding the Impact and Risks

As a Market Participant, dealing with in-the-money call options can be both profitable and risky. This article provides a comprehensive guide on what happens to both buyers and sellers of in-the-money call options at expiry, as well as the implications for insufficient funds in the account. We'll also explore the impact of new delivery margins in stock derivatives trading.

Understanding Buyer and Seller Positions at Expiry

The outcome of an in-the-money call option at expiry depends on whether you are the buyer or the seller. For buyers:

Ownership of the underlying stock at the strike price is transferred to the buyer. The stock is delivered to the buyer's account if the strike price is at or below the current market price.

For sellers:

The seller must deliver the underlying stock at the strike price if the buyer exercises the option. This means assuming a short position in the underlying stock.

If your account cannot accommodate the new shares, you may be required to deposit more funds or liquidate the positions. Brokers may also automatically liquidate your positions to mitigate risk according to their policies.

What Happens if the Account Balance is Insufficient

If the account balance is insufficient to buy the underlying stock when the option expires in-the-money, it can lead to several outcomes, depending on your agreement with your broker. In many cases, the broker will sell the call option around 30 minutes before the market closes on the expiration day.

Typically, if you have sufficient margin to exercise the option, it will be automatically exercised. In that case, you would need to either sell the stock or maintain the margin loan. However, the specific margin requirements and procedures can vary, so it's crucial to check with your broker.

New Delivery Margins and In-The-Money Options

The advent of new delivery margins in equity derivatives trading has significantly impacted how participants manage in-the-money options. These margins, also known as delivery margins, are levied on lower of potential deliverable positions or in-the-money long option positions four days prior to expiry.

For example, if the expiry of a derivative contract is on Thursday, delivery margins on potential in-the-money long option positions shall be applicable from the previous Friday's end of day (EOD).

This policy can create significant capital requirements for traders. If you're unable to arrange adequate margins, you may incur penalties, which can deter novice traders and less-informed participants. Trading index options can be a safer bet due to their cash-settled nature, making execution less capital-intensive.

Practical Example

Consider the following example:

You bought a XYZ stock at-the-money (ATM) option at 2 with a lot size of 10,000 shares. The underlying stock currently trades at 70. Before the expiry, the strike price of 70 goes in the money, and you start seeing significant profits on your position. However, on Friday before expiry, you may be hit with a penalty of 800,000 (1:8,000) due to a margin shortfall. If you cannot arrange 800,000 x 20 (16,000,000) by Friday close, you will attract a penalty on the margin shortfall. If the position is carried till Monday close, you should have 320,000 in your account.

This example clearly illustrates the importance of adequate capitalization when dealing with in-the-money call options at expiry.

Conclusion

Dealing with in-the-money call options can be fraught with challenges, especially if you don't have sufficient capital to cover your positions. Understanding the implications of expiry on both buyer and seller positions, as well as staying informed about delivery margins, can help you make more informed trading decisions. Always check with your broker regarding specific procedures and requirements to avoid penalties and manage your risk effectively.