Part 3 of our series on portfolio margin covers profit, loss, and what happens at expiration—eventually your position will expire, know what to expect.
Continuing our portfolio margin (PM) series, let’s look at how profit and loss are calculated, and what can be expected at option expiration.
In a PM account, a position’s margin requirement is based on two things. One, how much the position might lose if the price of its underlying changes by some percentage. And two, whether volatility, that is, uncertainty about changes in a stock's value, moves. This is a stress test, which is why knowing how to calculate profit and loss (P/L), and understanding what happens to an option position at expiration, are important.
Here’s an example to help explain P/L. Say you buy one share of XYZ at $50. If the price rises to $51, you can make a $1 profit. If the price drops to $49, you lose $1. Multiply that profit or loss by the number of shares you own, and you have the total P/L.
Now, PM tests the P/L if the underlying changes. In other words, what’s the P/L if XYZ drops 15%? If you're long 100 shares of XYZ at $50, and XYZ drops 15%, the price of XYZ drops by $7.50 ($50 x 15%) and goes from $50 to $42.50. The loss on 100 shares would be $750.
P/L for options works the same way, except that for most equity options, when the option price changes $1, the P/L changes $100 because of the option’s 100 contract multiplier. So if you buy one 50-strike call on XYZ for $3, and the value of the option drops to $2, the loss is $1 x 100, or $100. If the call option rises from $3 to $3.50, the profit would be $50.
The PM algorithm calculates the theoretical value for the options in the account positions. It comes up with a theoretical P/L based on changes in the underlying price and volatility. You don't need to figure this out, but you should know that at expiration, an option will either be out of the money (OTM) and worthless, or in the money (ITM) and worth its intrinsic value (difference between stock price and option's strike price).
Remember, the intrinsic value of a call is the prevailing stock price minus the call’s stock price. The intrinsic value of a put is the put’s strike price minus the prevailing stock price.
For example, if you buy a 50-strike call for $3, and the stock is $49 at expiration, the 50-strike call is OTM, which means it’s worthless at that time. The P/L would be ($0 – $3) x 100 = $300 loss.
If you buy a 50-strike call for $3 and the stock is $52 at expiration, the call will have $2 of intrinsic value. The P/L on the long call would be ($2 – $3) x 100 = $100 loss. If the stock is $55 at expiration, the call will have $5 of intrinsic value. The P/L on the long call would be ($5 – $3) x $100 = $200 profit.
These P/L calculations assume you close the ITM option position at expiration. If an option is ITM at expiration, and is not closed before the close of trading, it will likely be exercised or assigned and turned into stock. ITM long calls and short puts turn into long stock, while ITM short calls and long puts turn into short stock. If the stock is exactly at the strike price at expiration, it’s not automatically exercised or assigned. In this case, if you’re long that option, you’ll have to notify your broker of the intention to exercise it. And the person who’s short that option doesn’t know if it will be assigned because it depends on whether or not the long option holder exercises it.
Now that you have some idea of how theoretical P/L is calculated in a PM account, you’ll know what to keep an eye on as your option approaches expiration. Don’t end up owning something you didn’t want.
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