Options Q&A – September 28th, 2007

Friday, September 28, 2007

Filed Under Options Q&A's 

Q: If you buy a call and then sell it back into the market, are you in effect then writing a call and is all of the intrinsic value profit? For example, you buy 1 abc option for $200 at a strike price of $40 and the stock rises to $45. Is your total profit a guaranteed $300 if you close your position prior to expiry?   Tony

A:

Hi Tony,

Theoretically, all option prices must reflect all of their intrinsic value otherwise an arbitrage opportunity is present. In your example, with the stock at $45, the $40 call must be worth at least the $5 intrinsic value plus some time premium. If it did not, arbitrageurs would buy the undervalued call and simultaneously short the stock thus locking in a guaranteed profit. For example, assume the $40 call was missing 25-cents of intrinsic value and trading for $4.75. Arbitrageurs would short the stock at $45 and buy the call for $4.75 thus spending only $40.25. They could then immediately exercise the $40 call to cover the short position. They would get the $40 from the $40.25 credit thus leaving them with a 25-cent guaranteed profit, which is exactly the amount of missing intrinsic value.

However, this theory applies only to the asking price for options. Because of the bid-ask spread, you may see this not hold especially as expiration draws closer. So to answer your question, in MOST cases, you will always receive the full intrinsic value for your option (plus any time premium if applicable). In your example, with the stock at $45, you can be sure the $40 call would be trading for at least $5 (plus some time premium) and you would therefore capture the full $300 profit less commissions.

But even for those times when the bid price does drop below the intrinsic value, you can still get the full value with a little trick. For example, assume it is near expiration and the $40 call is only bidding $4.75 with the stock at $45. You have 10 contracts you’d like to sell. What can you do to get the additional 25 cents of missing intrinsic value? You do the same thing the arbitrageurs would. Simply short the stock and then immediately exercise the call. Doing so will entail one additional stock commission but you would collect an extra $250 from the trade!

Q: 

I would like to know when to use debt or credit spread? Thank you for your time. James Lin.

A: 

Hi James,

For any given set of strike prices, the debit and credit spreads should be identical in every respect. That’s the theory anyway. However, because of “skews” in the call and put prices, you will always find that the debit or credit version will be more advantageous in terms of price. Generally, you will not see any difference for the at-the-money strikes but will find potentially great differences as you move away from that central point.

For example, assume the stock is $102.50. You will likely find that the $100/$105 vertical call spread (buy the $100 call, sell the $105 call) can be purchased for $2.50, which means you could make $2.50 since the maximum value the spread could be worth is the $10 difference in strikes. However, if you wanted to buy an in-the-money vertical spread, you may decide to buy the $95/$100 strikes (buy $95, sell $100). This may cost, say, $4 thus allowing you to make a maximum of $1. Of course, it is less risky, which is why the market will bid the price higher. With the current stock price at $100, the $95/$100 spread only needs the stock to stay at the same price. It does not need the stock price to rise (although that certainly won’t hurt it).

Rather than buy the $95/$100 call spread though, you could also take a look at the $95/$100 put spread (buy $95 put, sell $100). In most cases, you will find there is a slight price advantage by using the put spread. Because market participants are willing to pay dearly for out-of-the-money puts as insurance, you may, for example, receive $1.10 credit. The most you could lose is the difference in strikes thus making your maximum loss $3.90. So the $95/$100 call spread costs $4 and can make $1 while the put version can make $1.10 but lose $3.90. In most cases, traders would use the put version since all other greek risks are identical.

You will discover a similar relationship when comparing the out-of-the-money call spreads with the in-the-money put spreads. Sometimes the debit spread turns out to be the better choice and other times it is the debit spread. The main point to understand is that you should never use a credit spread “just because” it appears to be better to receive money rather than spend it on a debit spread. Check the maximum gains and losses to find your answer.



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