Avoid Costly Mistakes When Trading Options

Option traders are prone to making errors – especially when encountering a puzzling situation for the first time.   From time to time, I'll post a discussion on how to avoid some of those mistakes.  NOTE:  I'm not referring to a trading mistake where you decide to buy some calls and ignore them until they expire worthless.  I'm referring to avoidable monetary losses.


Don't sell options under parity

That's pretty straightforward advice, but sometimes it seems to be unavoidable.  When an option is in the money, and especially when it's deep in the money, the bid price is often substantially lower than the option's true worth.  If you try to sell the call option at its intrinsic value, it's possible no one will buy it.  That's feels unfair to me, but you cannot force anyone to pay a fair price for your options.

Example, using call options

You own XYZ Oct 80 calls and the current stock price is 87.

The intrinsic value of this call option is $700.  The option is in the money by 7 points and the very least that this option is worth (depending on time remaining and the implied volatility of these options, it may be worth more than the intrinsic value) equals that 7 points, or $700.  For anyone who must see a formula, then:

Call intrinsic value = stock price minus strike price 

Put intrinsic value =  strike price minus stock price

Many times the market for such an option is: 6.80 bid, 7.20 ask. If you own these calls and want to sell, please, do not sell below intrinsic value.  That would be throwing away money.

You have two reasonable alternatives.  First, try to sell the call with a limit price equal to the options intrinsic value ($7 in this example).  If it does not sell quickly, wait until the stock is 87 bid.  Then cancel the sell order, exercise your call option (hopefully your broker allows you to do that online), and immediately sell your long stock at $87.

By taking that approach, you save some money by collecting the full intrinsic value of the option, and you don't have to settle for less.  One caveat:  If your broker charges a fee to exercise an option, please take into consideration that extra fee.  It may be better to sell option at $6.95.  Yes that's selling $5 under parity, but if you save a $10 fee, it's a better deal for you.

For readers who know that I believe an investor should almost never exercise a call option, this is one of the two exceptions.  When you would be forced to sell the option under parity (at less than its intrinsic value), exercise and sell stock, allowing you to collect the equivalent of parity for the option.

444


2 Responses to Avoid Costly Mistakes When Trading Options

  1. Jimmy J. 09/11/2009 at 9:47 AM #

    Hi Mark, another question. Do you have a recommended number of options you should hold at any one time? Im finding this will take some work to do it right, and holding too many at once might get out of hand. Thus I was wondering if your experience would suggest a recommended number of different options to be holding and working on at any one time? A recent stock seminar I took recommended to invest in 6-10 stocks at any one time, not sure how that translated into # of options at any one time.
    Thanks for your time!

  2. Mark Wolfinger 09/11/2009 at 10:18 AM #

    Good question.
    See reply in separate post 9/12/2009.