You may have noticed that in-the-money calls and puts can sometimes trade for less than their intrinsic amount (the difference between the stock and strike price). The problem seems much more prevalent 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 say that an option should not trade for less than its intrinsic value (less any commissions), things are rarely that simple in real life.
Many investors accept this as normal and close their positions below the intrinsic value. Despite what bid and ask prices are being quoted at the time, there is a better way to determine what you should get for a deep-in-the-money option. It is based on options pricing theory as it relates to arbitrage. An option should not trade for less than intrinsic value, because if it did, arbitrageurs could simultaneously trade the option and the underlying stock for a guaranteed profit. That buying and selling pressure would continue until intrinsic value is restored. So let's see how you might get a better price for your option and increase your trading profits.
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 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 market makers to do the trade). 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? The same way the arbitrageurs would. Instead of selling your call, place an order to sell the stock. Once the sell order has been executed, immediately exercise the call option.
In the example above, 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 your 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 well worth it.
Some people (including some brokers) may suggest you short the stock instead of putting in 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 three-business-day settlement period.
Selling Share That You Don't Have
You may also hear objections about selling shares that are not in your account, but regulations certainly allow it (although it is possible your individual broker may not). With real-time Internet trading, most shares are held by brokers in street name, and it's becoming hard to imagine a time when most investors kept share certificates in a safe deposit box and often called their brokers with sell orders for shares that were not in a brokerage account. As such, it is perfectly acceptable to put in a sell order without the shares in your account, as long as they are delivered within the three-day settlement period.
However, even if your firm requires the shares to be in your account for you to sell them, just let your broker know that you will be immediately submitting 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.
So once you sell the stock, it is very important to submit your exercise instructions on the same day. Otherwise, the sale of stock and purchase from the option exercise will not settle on the same day.
Closing Long Put Positions
What if you are instead long deep-in-the-money put options? Using the same example above, 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, you would receive 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 your puts.
In this example, you would pay $70.70 to buy the stock and receive $80 from the exercise of the put. You would then receive the full intrinsic value of $9.30, or $18,600, a difference $600! Again, the extra commissions will be well worth it.
Should You Try to Play Market Maker?
Why do options sometimes trade below their intrinsic value? It's usually because the market makers are having difficulty laying off their risk. Basically, it comes down to the law of supply and demand. There are more sellers than buyers. On (or near) expiration day, more traders may want to sell their options than buy them. The market maker is willing to buy, of course, but he or she will charge as big a premium as possible for providing that service.
The market makers are buying the call and then selling the stock. However, there may not be enough volume or interest to bring prices into equilibrium. If market makers buy the option and the stock continues to fall, by the time they short the stock they may be in for a loss. As a result, they charge a premium to cover their risk while awaiting executions.
Arbitrageurs and retail investors can also join in and buy the call and sell the stock, but if they do not already have an existing position, they have to purchase the option at the ask price and sell the stock at the bid. Even with the wider spreads common with deep in-the-money options, this leaves little or no room for error.
Competing With the Market Makers
After seeing the large differences involved in the above example, you may be tempted to think about trying to compete with the market makers. After all, that seems like a lot of money just sitting there to be picked up for little or no risk, but this is not a recommended strategy.
Let us assume that 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, for example, $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, the market maker(s) will bid $5.40, and all you are doing is giving them a call option for 10 cents! Why is that? It is because the market maker(s) would love to buy a deep in-the-money call below the 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 would use your buy order as their guaranteed stop order. 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 cases. 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 the 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 separate transactions (and at considerably less cost in commissions now than in the past).
The Bottom Line
To get the best return possible on your options trading, it is important to understand how options work and the markets in which they trade. Just because the market is offering you a price below fair value doesn't mean you have to accept it. And it certainly helps if you have a broker that fully understands options and can execute your instructions properly.