By Lawrence G. McMillan
This article was originally published in The Option Strategist Newsletter Volume 17, No. 4 on February 28, 2008.
Most option traders are acutely aware of their costs – especially commissions, but also bid-asked spreads, slippage, and so forth. But there is one area that can prove very costly to an option trader if he’s not aware of how to navigate it – and that is selling an option that should be worth parity, but is bid below that level. Most of the time – but not always – these “parity” situations arise at or near the option’s expiration date.
In this article, we’re not only going to look at how to exit a single option contract when the only bid is below parity, but also how to handle such options in spread trades – rolls near expiration, for example – and finally, how to handle the situation if you’re short the option and want to exit your position without paying too much to buy it back.
Exiting a Simple Long Position at Parity
This is a subject that has been written about many times by us and others. Nevertheless, we’ll review this basic exit technique, for it is the building block for other expiration-related exit strategies.
Example: You are long 10 BDX Mar 85 calls,
with the stock trading at 91.90. Parity for these
calls is 6.90 – the difference between the stock
price and the striking price. As a call owner, you
should always be able to sell your call for parity,
or more if there is any time value in it.
In this case, the market for the option is:
Bid 6.70, offered 7.10
So if you were to merely sell your option to the
maker bidding 6.70, you would be leaving
20 cents – $20.00 – on the table. Or more
accurately, you would be giving him the $20.
That is a huge waste of money. These days, at
discount firms, option commissions per contract
are $3.00 or less. Throwing away $20 per
contract, merely to exit the trade, is wasteful.
Market makers often bid less than parity,
knowing that if you hit their bid, they will quickly
be able to profit from it. But you can keep this
$20 discount for yourself by doing the following:
1) sell stock
2) exercise your calls
In this case, you’d sell 1,000 BDX at 91.90, and
exercise your 10 calls to buy 1,000 BDX at 85 –
the striking price. Thus, you take in 6.90 per
share on the stock trade. You get nothing in terms
of cash for your option since you exercised it, but
you have now effectively pocketed parity for your
option sale – receiving 6.90 instead of the 6.70
that the market maker was bidding.
You do not need to put up margin for this trade,1 although you will have to pay stock commissions. Some brokerage firms may ask for margin (at least day trade margin), but that is not required by any regulatory authority. If your brokerage firm is making it onerous for you to exit your calls at parity in this manner, then I would suggest you try a new brokerage firm.
Exiting a Put at Parity
To exit a long put option at parity, a similar set of steps takes place. Suppose you were long ZGEN Feb 12.5 puts as expiration approached. Assume the stock was trading at 8.90. Thus, parity for the puts is 12.5 – 8.90 = 3.60. However, the puts were 3.40 bid, offered at 3.80.
- To Exit Puts at Parity
- buy the stock
- exercise the puts
In this case, you’d buy stock at the current market price of 8.90, then exercise your put, allowing you to sell the stock at 12.50. Your put is now worthless to you since you exercised it, but you have taken in a credit of 12.50 minus 8.90, or 3.60 – the parity price for the put.
Again, you do not need to put up any money for this trade, as long as you issue an irrevocable exercise notice at or before the time the stock is bought.
Exiting a Spread at Expiration
Some traders understand the concepts just presented, but fail to extend them to other positions, such as spreads. In our previous newsletter, we had a long straddle in ZGEN Feb 12.5 options, and the puts were in the money – as in the previous example. We recommended rolling the Feb 12.5 puts out to the March 12.5 puts.
Here were the pertinent prices near mid-day: ZGEN: 8.90 Feb 12.5 put: 3.40 – 3.80 Mar 12.5 put: 3.40 – 3.80
Both put markets were the same, but we were trying to sell the Feb 12.5 put and buy the Mar 12.5 put – which would be a 40 cent debit at “the market” (buying at 3.80 and selling at 3.40). A lot of times, spread traders merely look at these markets, forgetting about the parity function, and bid something like 30 or 40 cents for the spread.
But note that parity for both options is 3.60 (see the previous example). Therefore, we know for sure that we can get 3.60 for the Feb 12.5 put. Hence we should bid at most 20 cents for this spread – willing to pay the offering price of 3.80 for the Mar 12.5 put, but expecting (rightfully) to receive at least parity for our long Feb 12.5 puts.
In fact, we were trading this position for our own account, and the market makers did not respond to the 20 cent bid for the entire day. So, near day’s end, we canceled the spread order. Then we bought the stock (at 8.89, I might add) – stock which was later sold at 12.5 via exercise of the Feb 12.5 puts, and we bought the Mar 12.5 puts at 3.80. In all, we sold the Feb 12.5 puts at 3.61 (the strike of 12.50 less the stock purchase price of 8.89) and bought Mar 12.5 puts at 3.80, so we “executed” the roll for a 19 cent debit overall.
If the option broker you are using has a multi-leg or “spread” platform, you might be able to simultaneously place an order to buy stock and buy the Mar 12.5 puts – for a total 12.70 debit, say. Or you can separately buy stock and then quickly buy the Mar 12.5 puts as soon as your stock order is filled.
This strategy works best at a deep discount broker, or course, since you have slightly more commission costs.
So, if you are rolling long options at expiration, don’t just look at the spread market on the screen. Rather, figure your expiring long option to be worth at least parity and make your bid off that value. If the market makers don’t “bite,” then you can always use the above methods to extract parity value for your long option, and execute the other side of the spread as a direct order.
Short Options at Expiration
If you are short options heading into expiration, things work in a similar manner, but there is a major difference – you are not in control of the exercise. Therefore, there is some risk to your trade, and your brokerage firm will require margin for the trade. Having said that, here’s how it might work.
Example: suppose you have a covered write of the aforementioned BDX Mar 85 calls on the last trading day prior to March expiration, and would like to roll to the June 85 calls. Here are the pertinent markets;
BDX: 91.90 (you are long 100 shares) Mar 85 call: 6.70 – 7.10 (you are short 1 call) Jun 85 call: 8.90 – 9.50
At first glance, it would appear that the roll can be done for a credit of 1.80 – buying back the Mar 85 calls for 7.10 and selling the June 85 calls for 8.90. However, it is again important to realize what parity is for the near-term option. In this case, it’s 6.90 (the stock price of 91.90 minus the striking price of 85). There is no real reason why one should pay 20 cents above parity on the last trading day to buy back an in-the-money option. But what can be done? A trade with a small amount of risk can be undertaken: 1) buy 100 shares of stock at 91.90 2) sell the June 85 call at 8.90 As long as the stock stays above 85 for the next few hours (or minutes, depending on how close to the end of the trading day you make this trade), the Mar 85 call will be assigned – calling away the stock you just bought. That leaves you with: Long the original 100 shares of stock Short 1 June 85 call So, you rolled your covered write out. At what price? You bought stock at 91.90 which was called away at 85 – a loss of 6.90 – and you sold the June 85 call for 8.90. So your net credit is 2.00 points, less commissions.
Your brokerage firm will require that this trade be margined for there is some slight chance that the stock could fall below 85 and not be called away (for example, some news might be announced between the time you make your trade and the time that final exercise notices are due – at 5pm Friday evening on the last trading day). So, if you have the equity available to do a trade such as this, you can equivalently buy back a short, in-themoney option at parity by buying stock and letting it be called away.
Exisitng Short Puts
In a similar manner, you could exit a short put at parity by selling the stock short against the expiring in-the-money put, in anticipation of the put being assigned and the stock thus being bought back via the assignment.
Again, you would have to have the equity in your account to use this method. Theoretically, your brokerage firm might also want to make sure that the stock is borrowable, although that is probably not necessary since you are planning to be assigned the same day. Still, if your firm is a stickler for dotting i’s and crossing t’s, they will not let you short the stock against the short puts unless the stock is borrowable.
Summary
As noted at the beginning of this article, option traders are quite aware of their costs. The most obvious of these is commissions, and many traders have moved to one of the various discount firms that specialize in options: OptionsHouse, Terranova, Options Express, Interactive Brokers, and so forth.
But that only solves part of the problem. Another big cost factor can be the bid-asked spread of a routine option order. The best way to control costs in this area is to deal with a firm that allows you to choose the exchange where you want to send your order (or for the brokerage firm’s computers to make a similar decision). However, many brokerage firms receive payment for order flow and always send their orders to the same exchange. That is not the most efficient trade for the customer.
Finally, the last factor that can be controlled by the option trader is his exit price for parity options. If you are diligent about the others, but ignore this factor, you will cost yourself a lot of money. So, employ the techniques in the article. We don’t normally have the room or the inclination to spell this out in detail in our follow-up recommendations, but each expiration we exit or roll a large number of trades, and subscribers should use these techniques where applicable.
This article was originally published in The Option Strategist Newsletter Volume 17, No. 4 on February 28, 2008.
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