In-the-money calls and puts often trade for less than their intrinsic value the difference between the stock price and strike price on, or near, expiration day. This is especially true for deep-in-the-money options. It also seems like once you get close to expiration day and there is very little time premium left in deep in-the-money options, the problem is even more prevalent. Let me give an example based on real-life situation I saw recently.
Many investors would accept this as normal and close their positions below the intrinsic value. After all, while options pricing theory may say that an option should not trade for less than its intrinsic value less any commissions , things are rarely as neat in real life, right? There are ways that you can get the full value for your option position.
But there is a better way, and it is based on options pricing theory. Option theory is partially based on the idea of arbitrage, and it says that an option should not trade for less than intrinsic value.
If it does, arbitrageurs would sell the stock and buy the call for a guaranteed profit. The buying and selling pressure would continue until the option price equals its intrinsic value. So how can you close an in-the-money option that is trading below parity? The same way the arbitrageurs would.
Instead of selling your call at the bid, place an order to sell the stock. Once that sell order has been executed, immediately exercise the call option. Once the sell order is executed you then submit your exercise instructions to your broker. It is possible that the commission charge from your broker may be slightly more to do it this way, but not necessarily. However, shorting the stock subjects you to unnecessary risk. You may hear objections about selling shares that are not in your account.
But the regulations certainly allow it although it is possible you have an individual broker that does not. In these days of Internet trading, with most shares held by brokers in street name, it may be hard to remember back to when most investors kept stock certificates in a safe deposit box and often called in sell orders without the shares at the brokerage firm.
But it is perfectly acceptable to put in a sell order without the shares being physically at your brokerage firm as long as they are delivered within the settlement period. Even if your firm does require the shares to be in your account for you to sell them, just let your broker know that you will be immediately submitting exercise instructions to purchase the shares.
So once you sell the stock, immediately submit exercise instructions. It is important to submit your exercise instructions on the same day or the sale of stock and purchase from the option exercise will not settle on the same day. Closing Long Put Positions What if instead you are long put options? The way to capture this difference in the case of put options if they are trading below intrinsic value is to buy the stock and then exercise your puts. Again, any extra commissions you may have to pay will be well worth it.
Why do options sometimes trade below their intrinsic value? It usually is because the market makers are having difficulty laying off their risk.
But it basically comes down to the law of supply and demand. There are simply more sellers than buyers. On or near expiration day, everybody wants to sell their calls, but nobody wants to buy them. The market maker is always willing to buy, of course, but he will naturally try to get as big a premium as he can get for providing that service. The answer is that they are. The market makers are buying at the bid price and then selling the stock. However, there can be times where there is not enough volume or interest to bring prices into equilibrium.
If the market maker buys the call option from you and the stock continues to fall, they end up with a loss by the time they short the stock. So they charge a premium to cover their risk while awaiting executions. What about arbitrageurs or retail investors?
They can, but not only will they have commission costs, they have to purchase the call at the ask price and sell the stock at the bid price. With the wider spreads common with deep in-the-money options that leaves little or no room for error.
When you notice large differences between the quoted price and intrinsic value, you may be tempted to think about trying to compete with the market makers. After all, that looks like a lot of money just sitting there to be picked up for little or no risk. But I would not recommend it. Now you are the highest bidder. But there is a catch: How do I know that will happen? Because you would be giving them a call option for 10 cents! Market makers love to buy deep in-the-money call below their fair value.
For almost no risk, their worst possible outcome would be losing 10 cents. In other words, they would use your buy order as their guaranteed stop order. It meant the broker would sell the stock, covering the sale by exercising the call or to buy the stock and cover by exercising the put.
To get the best return you possibly can, it is important to understand how options work and the markets they trade in. And it also helps considerably if you have a broker that fully understands options and can execute your instructions properly.
Len Yates is the President and founder of OptionVue Systems International and has earned worldwide recognition for his groundbreaking work in options analysis software. He has published numerous books and articles on options analysis and trading strategies, and is a primary contributor for the educational site DiscoverOptions. At Connors Research, we are using it as an overlay to many of our best strategies to make them even better -- now you can, too.
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