Exercising, trading, and investing with options II

This is Part II.  (Part I)

Questions/comments from Scott:

One of the quotes I wrote down from the
Options Clearing Corporation states “we usually see options exercised early if
the option holder is able to buy below parity."

Years
ago, when I was a market maker, whenever I sold stock short, I
collected interest on the cash generated.  One reason that was a
wonderful benefit can be seen when I was able to buy a call option near
parity.  I would then sell stock short and have a put that was better
than free.  I would earn more in interest than I had to pay in time
premium.  Thus, I was guaranteed a profit – just from the interest. 
And,
if the stock ever fell below the strike of the call, that would be even
better.  The stock drops in value and the calls moves to worthless.  An
opportunity for extra profit as the stock falls farther.  This
position, long call, short stock is equivalent to a put.  And to get it
for free was just great.

Thus, if I bought that call, I would never exercise before expiration.  I'd keep the free put.

The
world is different today.  I don't know if anyone collects interest on
short stock, but I doubt it.  In fact, many have to pay interest when
they borrow shares to sell short.  No matter.  The point is this:  If a
market maker can buy calls under parity and then sell stock, there is
nothing to be gained by holding the position when it is deep ITM.  The
free put doesn't have much value and if paying interest to own the
position, it's better to get rid of the position and take the profit.

Example: 
Stock is $80.  Buy the Nov 60 call, paying $19.90.  Sell stock short at
$80, exercise the call and collect the free profit of $10, less
commissions.  It's these professional traders who occasionally get to
buy puts and calls below parity.  These are the traders who hedge with
stock and then exercise.

This
has nothing do to with you or any other individual investor.  It's
virtually impossible for you to buy options under parity and take
advantage of this.  But where this affects you is being certain that
you do not misinterpret that line from the OCC as a suggestion that
exercising such calls is beneficial to you. 
Unless
there is a dividend you want to collect (and often it does not pay to
collect it), do not exercise any call option prior to expiration. 
That's essentially true for puts also, but there is an exception (You
own DITM puts and stock.  By exercising you eliminate position and save
the cost to carry.  But you are giving up the upside profit opportunity
if stock rallies above strike).

***

Do you have a
plan to earn a profit when you buy out of the money calls? What are the details
of that plan?


Of course I plan to earn a profit—as to the details of the plan, that is
the purpose for reading books and asking questions.


I was referring to the details of the plan.  Most, dare I say all?,
traders in your shoes buy OTM options and sell them at some point. 
Holding to expiration kills all the time premium you paid, and that
makes it even more difficult to earn a profit.  If that's your plan
(holding to the end and exercising) that's truly not a good plan.  If
you are a stock trader, why not be an options trader instead of becoming an options investor?

***

In hindsight, this was not a very good example. I’ll try again: In August
I wrote down the options chain for AIB. The stock was selling for $5.25. The
premium on the SEP 5 was $0.45. In mid-September AIB broke $9.50 and I could
have sold the OCT 10 option for $1.15. Shortly after, AIB fell below $6.00.

Would
it have been better to exercise the option or to sell it?

If I exercised the
option and sold the shares I would have made ($9.50-$5.45 X 100) = $405 per
contract.
If I had resold the option I would have made ($1.15 X 100 –
original premium of $45) = $70 per contract.

Is the math
right?

It would have been better to sell it.Yes, the math is correct.

But you were describing the sale of the
Oct 10 call at $1.15.  You want to sell the Oct 5 call, which was
obviously trading at a much higher price. 
The price would
have been at least $4.50 (parity), and perhaps a bit higher.


Suggestion: For clarity it's better to refer to the Oct 5 call, rather than the 'Oct 5 option.'

***

(Describing a put option that is in the money by $5 per share) …But once again, just sell your option,
collecting $5 for the same profit. Why exercise?

What if the option premium is less than $5? 

That's one time to exercise the option and sell the shares.  Although the bid for an option can be under parity, it only happens when the option is deep in the money.

***

Please, do yourself a big favor. Get a copy of The Rookie's Guide to Options.
Read it. All the details are there to help you understand what you are doing
when trading options.


I do plan to get a copy of your book.

***

Once again,
thank you for the time and thought you put into your replies—it is greatly
appreciated.


Scott,

Thanks Scott.  When the questions are
thoughtful, I'm very happy to do it.  You clearly know what you are
doing as a trader – but options are still new to you and learning the
answers does not come from osmosis.  You are making the effort, and
that's what it takes.

Good trading.

513

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