RE: Deep in the money puts Final Thoughts
Received this PM from a lurker who gave me permission to post:
RE: Shorting Put Leaps
I am forced to be a lurker on this board. To post would be inappropriate, even if the issue is off topic, such as this one on option strategy.
However, people should be aware of the issues surrounding deep in the money (DITM) puts. I have used them several times for short term loans. However, that is exactly how they should be treated.
Remember, most option models, and many of them are very accurate, consider the arbitrage opportunities in determining the relative value of Puts and Calls.
A synthetic long position can be created with a long Call and a short Put. If a trader can short a stock and earn the interest on the money received while being flat the position by also owning a synthetic long, he/she would do so in large numbers. (This position is known as a "Reverse Conversion") Calls are always priced more expensively than Puts to cover this possibility. The Call will nominally be more expensive by the same amount that the trader would earn
in interest at a risk free (US government) interest rate, over the period until expiration.
For strike prices near the money, this is almost always exactly true. However, this model falls apart as the strike prices are significantly above the market price of the underlying. When this occurs, the price of the Put should decline below parity. With American style options, this cannot occur, because they would immediately be bought and exercised by someone with low transaction costs. Therefore, the Put is overvalued when it is far out of the money. This
creates the “interest arbitrage” that the “lurker” is discussing taking advantage of.
Any DITM Puts that are outstanding are owned by people that are not aware of (or not paying attention to) the true cost of owning them. Maybe someone bought them when they were near the money and they are still holding them out of ignorance. Early exercise is always going to occur with a professional trader.
If you watch the Volume and Open Interest for a deep in the money Put, you will see that they are very out of sync. There may be long periods where there is no Volume, but the Open Interest slowly drops. These are indications of early exercise.
Other times, there is Volume, but the next day, the open interest has not changed. This is likely to be a professional trader took the buy side of the trade to make the market, bought the stock and did an early exercise. With low transaction costs, this will leave them with a small profit. Meanwhile, the trader that sold the Puts is enjoying his/her “free interest income”. However, someone got an early exercise. Remember, all options are cleared via the Options Clearing Corporation (OCC). There is no 1 to 1 relationship between the buyer and seller of an option. Once a transaction has occurred, the new contract(s) is just
another entry in the “open Interest” for the option. When a contract is exercised, one of the clearing houses that represents sellers of these contracts is selected (lottery, so they say) for exercise. How an individual is selected within each clearing house is up to the clearing house. Lottery is an option, but not required. (Read that, small fish, watch out…)
So, in the example given, if someone sells 10 Jan 03 AMAT Puts, VPJMF, for 75 ¾ and, since this is an interest play, he might as well also short AMAT at 54 3/16. He will have received 129 15/16 in cash for an obligation to buy AMAT back for 130 in January 2003. In this example, if it can be executed, he/she is risking 1/16, that’s $62.50 plus commissions for a total cost of $100 to $150, for the use of $130,000 for over 27 months. Not a bad interest rate!
However, most likely, when this trader sold the 10 contracts, 10 contracts were also exercised by the professional trader on the buy side. With the lottery
method, it is unlikely that the writer of these new options is the one selected for early exercise. So he/she has a free ride for a while, until someone else discovers the method, sells a few contracts and the lottery comes up with their name on it.
Sorry to ramble on, but to expect more than short term use of the funds is dangerous. Eventually, the Open Interest on DITM Puts drifts toward zero. |
