Why is Buying Stock Options Close to the Expiry Not Allowed

Introduction

• For traders, stock options are flexible and a potentially profitable way to invest in the stock markets. However, as the expiration dates of these options approach, certain restrictions and considerations come into play.
• An expiration date is the last date by which any product or service will be used. At the same time, it also signals the conclusion of contracts or assets in markets.
• In the context of futures and options contracts, expiration refers to the date your contracts cease to remain valid; it is also known as the last day of validity.
• Buying stock options nearing expiration is not allowed, and there are a few reasons for this.

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What are Stock Options?

• Options trading involves buying or selling options contracts. These agreements allow the holder to purchase or sell an underlying security at an agreed-upon price by a specific date.
• Investors or traders who purchase options can exercise them at any point before the expiration date. 
• The purchase or sale of an option does not put its holder under any obligation to exercise it at its expiration date, making options a good derivative security.

Why are Stock Options Close to Expiration not Preferred?

• No new buy positions or long positions in stock options should be established on Wednesday or Thursday before expiration, as contracts could become due for physical settlement. 
• Margin requirements can skyrocket if a client's options contracts become due for physical delivery. 
• Exiting inherently illiquid stock options quickly becomes challenging, thus increasing the brokerage firm's risk.

A few other key reasons are as follows:

• Lack of liquidity: As options approach expiration dates, their trading volume and liquidity tend to decrease. This makes it harder for buyers or sellers to find desirable prices to trade them at. This reduced liquidity may also result in wider bid-ask spreads and increased transaction costs, prompting some investors to forego trading near expiration due to limited liquidity. As such, investors may choose not to trade options close to expiration.
• Time decay: As options get closer to expiration, their time value dips faster. This demonstrates their decreasing extrinsic value, or 'theta'. As a result, buying options close to expiration means less time for the underlying stock to move significantly. This can make them risky or unprofitable investments.
• Higher volatility: Options prices are determined by stock price volatility, more commonly measured as implied volatility. As an option approaches its expiration date, its likelihood of significant price swings decreases. Also, the implied volatility tends to decrease accordingly, adversely affecting options prices. Lower implied volatility decreases investment return potential and may discourage some investors from purchasing options close to expiration.
• Increased risk: Options trading always involves risk, but buying options close to expiration can be especially risky. With less time remaining until expiration, an option's value becomes even more sensitive to fluctuations in its underlying stock price, increasing your potential loss if things move against you.

Conclusion

• At expiration, options become riskier and less profitable because of time decay, diminished potential stock price movements, and increased risk. 
• Investors must stay up-to-date and adapt their trading strategies to understand the complex dynamics of options trading and make profitable transactions. 

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