How To Avoid Closing Options Below Intrinsic Value

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How To Avoid Closing Options Below Intrinsic Value

In-the-money (ITM) calls and puts may occasionally trade for less than their intrinsic value (the difference between the stock and strike price), with this happening becoming more prevalent as expiry day approaches. Deep-in-the-money options have very little time premium remaining on expiry day, and their entire value is intrinsic value. While options pricing theory may argue that an option should never trade for less than its inherent value (before fees), real-world trading is seldom that straightforward.

Many investors accept this as usual and close out holdings at or below intrinsic value, but there is a better approach to figure out what you should pay for a deep-in-the-money option. In theory, an option should not trade for less than its inherent value since it would allow arbitrageurs to trade both the option and the underlying stock for a guaranteed profit, with such transactions continuing until the intrinsic value is restored. With this in mind, let’s look at how you may receive a higher price for your option while also increasing your earnings.

Key Takeaways

  • According to options pricing theory, an option’s premium will never trade below its inherent value owing to arbitrage.
  • In actuality, owing to market inefficiencies and frictions, a deeply in-the-money call or put may trade for less than its fair value.
  • Closing out or executing deep in-the-money options positions may be an effective strategy for avoiding loss due to these difficulties.

Closing Long Call Positions

Assume that the stock of XYZ Corp is now trading at $70.70 on December expiry day, and you possess 20 December $65 calls that you want to cancel (sell).The December $65 calls should be trading at or around parity, which is $70.70 – $65 = $5.70. However, if you sell the calls, you will notice that it is priced at $5.20. The profits would be as follows:

$5.20 x 20 x 100 = $10,400

Naturally, you may attempt to sell at $5.70 (or, more realistically, $5.60—leaving a penny for the bid/ask spread). But suppose you do that and are unable to have the order completed at that price. How else can an in-the-money option that is trading below parity be closed? Instead of selling the call, put an order to sell the stock like an arbitrageur. Then, as soon as the sell order is completed, exercise the call option.

  Using Quantitative Investment Strategies

The stock in the example is presently trading at $70.70. In this scenario, you’d place a sell order for 2,000 shares at $70.70. Following the execution of the sell order, you just give exercise instructions to the broker. According to the terms of the option contract, you will purchase 2,000 shares at the strike price of $65. So you sell the stock for $70.70 and then purchase it again for $65 on the exercise. The revenues will be as follows:

(2,000 x $70.70) – (2,000 x $65) = $141,400 – $130,000 = $11,400

That’s an additional $1,000 in your pocket.

It may cost a bit more to accomplish it this way, but if the choice is much below parity, it should be worth it.

Brokers may advise you to short the stock rather than place a conventional sell order. Shorting the stock, on the other hand, is subject to Regulation T, and you may not receive interest on the amount throughout the settlement period.

Delivering Non-Owned Shares

You may encounter objections to selling shares that are not in your account, but rules permit it, even if your broker does not. The majority of shares are held in street name by brokers, and it is completely legitimate to place a sell order without the shares as long as they are delivered within the settlement period. If the broker demands that you hold the shares before selling them, inform them that you will immediately send exercise instructions to acquire the shares. There is no reason why this should not be permitted since the Options Clearing Corporation assures the delivery of the shares upon settlement.

It is critical to provide workout instructions on the same day you sell the shares. Otherwise, the stock sale and option exercise buy will not settle at the same time.

Closing Long Put Positions

What if you have a position in deep-in-the-money put options? In the same vein, suppose you are long December $80 puts that are being priced at $9.00. Selling 20 of those puts to finish off your trade would result in a $18,000 profit.

  Gauging Support and Resistance With Price by Volume

However, since the company is now priced at $70.70, the intrinsic value of those put options is $80 – $70.70 = $9.30, a difference of 30 cents. When put options are trading below their intrinsic value, you simply purchase the stock and then execute the put options.

You would pay $70.70 for the shares and get $80 if you exercised the put. You would then be paid the entire intrinsic value of $9.30, or $18,600, a $600 difference. Again, the increased commissions will be well worth the extra work.

Market Makers

Why do options sometimes trade below intrinsic value? It’s generally because algos or market makers are having trouble mitigating risk. It all boils down to the rule of supply and demand. If there are more selling than purchasers on the expiry day, an imbalance may occur, allowing the algo or market maker to demand a hefty premium for completing the deal.

The market makers at algosor are buying the call and selling the stock. However, there may not be sufficient volume or interest to put prices back into balance. If they acquire the option and the price continues to decrease, they may incur a loss by the time they sell the option. As a consequence, they charge a premium to cover the risk while the execution is pending.

Arbitrageurs and retail investors may participate by buying the call and selling the stock, but if they do not already have a stake, they must buy the option at the ask price and sell the shares at the bid price. With widespreads being typical with deep in-the-money options, there is minimal space for mistake.

Competing With Market Makers

You could be tempted to compete with algos and market makers by replicating their techniques. While it seems to be low hanging fruit, this is not a recommended method.

  How Stock Options Are Taxed & Reported

Assume the December $65 call option was priced at $5.20 bid and $5.90 asking. So, what if you just placed an order (for ten or more contracts) at the slightly higher bid price of $5.30? Now that you’ve got the best pricing, the quotation will change to $5.30 on the bid and $5.90 on the ask. If you get struck at $5.30, you may sell the stock and profit quickly.

However, there is a catch. If you bid $5.30, algos and market makers will bid $5.40, and you are offering them a 10-cent call option! This occurs because they may profit by purchasing a deep in-the-money call at a cheap price. If the price of the stock declines while your bid is open, the market maker will sell it to you for $5.30. Their worst-case scenario would be a loss of 10 cents for very little risk. In other words, your purchase order serves as their guaranteed stop order. So, if they purchase the option for $5.40 and it fails, they know they have a buyer at $5.30 – you!

In similar situations, there used to be an instruction termed “exercise and cover.” It indicated that the broker would sell the shares and pay the loss by exercising the call (or buy the stock and covering by exercising the put).This order is no longer utilized due to greater liquidity in the options markets, but that doesn’t mean you can’t execute it yourself in two transactions and at a far lower cost in fees.

The Bottom Line

Understand how options operate and the markets in which they trade to receive the highest return. This involves realizing that if the market offers you a price that is less than fair value, you do not have to accept it.

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