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Buying In-the-Money Options
The Smart Profits Report: Issue #301
Tuesday, April 18, 2006
Buying In-the-Money Options: A Profitable Exit Strategy for Expiration Week
By Jim Stanton
Advisory Panelist, Mt. Vernon Research
I’ve hit a number of home runs in the option market over the years using cheap, out-of-the-money puts and calls. But believe me, the number of options that expire worthless using this method far exceeds the number of profitable ones. And that’s why I’m a bigger fan of buying in-the-money options.
But if you’re holding in-the-money options - and sitting on gains - selling them at a fair price can be a chore all by itself.
Today’s column covers an exit strategy for profitable, in-the-money options going into expiration week. When the options are bidding below their intrinsic value (the difference between the stock and strike price), sometimes you have to get creative to realize your gains. Let me show you how…
Don’t Fight the Market Maker
When looking at any option chain, the most active options are usually slightly out-of-the-money and have the tightest bid/ask spread. But with deeper in-the-money options - especially in stocks that are less active - the bid/ask spread is wider. This is not only true in the weeks prior to expiration. I’ve seen it many times during expiration week, too.
One would think that with the heightened interest in options these days, and the sophisticated software available, the spreads would have improved over the years. But in the end, it comes down to the risk that the market makers are willing to take, and that’s a function of volume and how greedy or risk-averse the market maker is.
While option-pricing models say that an in-the-money option should not trade below intrinsic value (minus commissions) on expiration day, in real life, that’s not always the case.
Most traders accept the discounted bid price and go on to the next trade. But they don’t have to…
Capturing All Your Profit Buying In the Money Options
Let’s assume that on April 21, 2006 (expiration day) stock XYZ is trading at $50.50. Let’s also assume you own 20 of the April $45 in-the-money calls and want to sell the position. The intrinsic value is $5.50 ($50.50 minus $45), but if the stock and option are thinly traded, the bid/ask may be $5/$5.60 with very little volume. By selling at the bid price, your proceeds would be:
$5 x 20 x 100 (shares per contract) = $10,000
You could attempt to use a limit order at around $5.40 or $5.50, but the market maker knows you probably need to sell. So, unless he gets an offsetting order, you probably won’t get filled. If this occurs, you have to take on the role of arbitrager. Here’s how it’s done.
Instead of selling the call at a discounted bid, sell 2,000 shares of the stock (the number of shares 20 contracts controls) at $50.50 and immediately alert your broker that you are exercising the 20 option contracts. You will receive $50.50 for the stock and then buy it for $45 as per the exercise agreement. The proceeds would be the following:
- The return from selling the stock (2,000 x $50.50 = $101,000)
- Minus the return from buying it back (2,000 x $45.00 = $90,000)
- Nets $11,000.
That puts an extra $1,000, or 10% more, into your account. You will pay an extra commission using this strategy, but the commissions have gotten so cheap, especially when trading online, that your net should be close to $950.
No Mercy For The Market Maker
I would not sell the stock short because of the uptick rule, which means it’s possible you won’t get filled and could be subject to additional SEC regulations. Make sure the firm you are dealing with is aware of your strategy. It should not require that you put up additional funds for the stock sale as long as you do the sale and exercise on the same day. That way the settlement day for both transactions is the same.
If you are long an in-the-money put option, which is trading below the intrinsic value, the strategy is done in reverse. Buy the stock and exercise the put on the same day.
In either situation, you will get very close to what your in-the-money options are really worth and not be at the mercy of the market maker, only the market itself.
Good Trading,
Jim
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Today’s Smart Profits Cribsheet
- In options trading, there are many variables beyond your control, and the bid and the ask prices, as we’ve seen today, are some of them. But we’ve also seen that there’s a way to maximize your trades despite the market maker’s influence. Another way to optimize your options trading is by practicing superior money management. Check out Smart Profits #286, Understanding Option Trading: Cut Your Losses… And Watch Your Winners Run for profitable money management tactics.
- Remember, there are at-, out-, and in-the-money options. An option is “at-the-money” when the strike price of the option equals the market price of its underlying security. An example: If Nike is trading at $75, then the Nike $75 call option would be “at-the-money,” essentially at a break-even point. For more helpful terms, see the Smart Profits Glossary.
Related Articles:
- In the Money Options: Make Mondays Your Discount Stock-Buying Day
- Options Trading Strategy: A Five-Question Screen to Find the Perfect Option
- Position Sizing: The Most Powerful Investment Concept
