How To Avoid Closing Options Below Intrinsic Value

In-the-money (ITM) calls and puts can sometimes trade for less than their intrinsic amount (i.e. the difference between the stock and strike price), with the occurrence more common for deep-in-the-money options as you approach expiration day. On expiration day, there is very little time premium left in deep-in-the-money options and nearly their entire value is intrinsic value. While options pricing theory may insist that an option should never trade for less than its intrinsic value (without accounting for commissions), real life trading is rarely that simple.

Many investors accept this as normal and close out positions below intrinsic value but there is a better way to determine what you should get for a deep-in-the-money option. Theoretically, an option should not trade for less than intrinsic value because it would let arbitrageurs simultaneously trade the option and underlying stock for a guaranteed profit, with those transactions continuing until intrinsic value is restored. With this in mind, let’s see how you might get a better price for your option and increase profits.

Key Takeaways

• Options pricing theory suggests that an option’s premium will never trade below its intrinsic value due to arbitrage.
• In reality, a deeply in-the-money call or put may trade for less than its fair value in the market due to inefficiencies and frictions.
• Closing out or exercising deep in-the-money options positions can be a good tactic to avoid losing out to these issues.

Closing Long Call Positions

Let’s say that on the December expiration day, the stock of XYZ Corp is currently trading at $70.70 and you own 20 of December $65 calls that you would like to close (sell). The December $65 calls should be trading at or very near to the parity price of $70.70 – $65 = $5.70. However, you see that it is being quoted at $5.20 if you sell the calls. The proceeds would be:

$5.20 x 20 x 100 = $10,400

Naturally, you can try to place a limit order to sell at $5.70 (or more reasonably, $5.60—leaving a dime for the bid/ask spread). But let’s say you try that and cannot get the order executed at that price. How else can you close an in-the-money option that is trading below parity? Like an arbitrageur, place an order to sell the stock instead of selling the call. Then, when the sell order is executed, immediately exercise the call option. 

In the example, the stock is currently trading at $70.70. In this case, you would place an order to sell 2,000 shares at $70.70. Once the sell order is executed, you simply submit exercise instructions to the broker. The terms of the option contract mean you will buy 2,000 shares at the strike price of $65. So you receive $70.70 a share on the stock sale and then buy it for $65 on the exercise. The proceeds will be:

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

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

Your broker may charge a little more to do it this way, but if the option is substantially below parity, it should be worth it. 

Brokers may suggest you short the stock instead of placing a regular sell order. However, if you short the stock, you are subject to Regulation T and you may not earn interest on that amount over the settlement period.

Delivering Non-Owned Shares

You may hear objections about selling shares that are not in your account but regulations allow it, even if your broker may not. Most shares are held by brokers in street name and it is perfectly acceptable to put in a sell order without the shares, as long as they are delivered within the settlement period. If the broker requires that shares be held before selling them, advise you will immediately submit exercise instructions to purchase the shares. There is no reason this shouldn’t be allowed because the Options Clearing Corporation guarantees delivery of the shares at settlement.

Once you sell the stock, it is very important to submit exercise instructions on the same day. Otherwise, the sale of stock and purchase from the option exercise will not settle at the same time. 

Closing Long Put Positions

What if you are long deep-in-the-money put options? In the same example, let’s say you are long December $80 puts and they are being quoted at $9.00. Selling 20 of those puts to close out your position would net proceeds of $18,000.

However, because the stock is trading at $70.70, those put options have an intrinsic value of $80 – $70.70 = $9.30, a difference of 30 cents. In the case of put options trading below intrinsic value, you simply need to buy the stock and then exercise the puts.

You would pay $70.70 to buy the stock and receive $80 from the put exercise. You would then receive the full intrinsic value of $9.30, or $18,600, a difference of $600. Again, the extra commissions will be well worth the additional effort.

Market Makers

Why do options sometimes trade below intrinsic value? It’s usually because algos or market makers are having difficulty laying off risk. Basically, it comes down to the law of supply and demand. If there are more sellers than buyers on expiration day, it may generate an imbalance that allows the algo or market maker to charge a high premium for completing the transaction.

The algos or market makers are buying the call and selling the stock. However, there may not be enough volume or interest to bring prices into equilibrium. If they buy the option and the stock continues to fall, it could generate a loss by the time they short the stock. As a result, they charge a premium to cover the risk while awaiting execution.

Arbitrageurs and retail investors can join in and buy the call and sell the stock, but if they do not have an existing position, they have to purchase the option at the ask price and sell the stock at the bid. With wide spreads common in deep in-the-money options, this leaves little or no room for error.

Competing With Market Makers

You may be tempted to compete with algos and market makers, mimicking their strategies. While it seems like low hanging fruit waiting to be picked, this is not a recommended strategy.

Let us assume the December $65 call option was being quoted as $5.20 bid and $5.90 asked. So what if you simply put in an order (for 10 or more contracts) at a slightly higher bid price of $5.30? Now you have the best price and the quote will move to $5.30 on the bid and $5.90 on the ask. If you get hit at $5.30, you can sell the stock and make a quick profit.

But there is a catch. If you bid at $5.30, algos and market makers will bid $5.40 and you are giving them a call option for 10 cents! This happens because they can make money by buying a deep in-the-money call below fair value. If the stock falls while your bid is open, the market maker will sell it to you at $5.30. For very little risk, their worst outcome would be losing 10 cents. In other words, they use your buy order as their guaranteed stop order. So, if they buy the option for $5.40 and it doesn’t work out, they know they have a buyer at $5.30 – you!

There used to be an order called “exercise and cover” to use in these circumstances. It meant the broker would sell the stock, covering the sale by exercising the call (or buy the stock and covering by exercising the put). With increased liquidity in the options markets, this order is no longer used, but that doesn’t mean you can’t do it yourself in two transactions and at considerably less cost in commissions.

The Bottom Line

To get the best return, understand how options work and the markets in which they trade. This includes understanding that, if the market is offering you a price below fair value, you don’t have to accept it. 

Read the original article on Investopedia.