Exercise PUT option before expiration

[scaft]

Hi,

(Below example is not a scenario if the stock has a dividends. Courtage for stocks are also ignored)

I have heard this statement for an "In-The-Money"(ITM) PUT option which is the one I am searching the answer to:

"Sometimes it is better to let the option to expire ITM and let it exercise automatically
rather than exercise manually prior to expiration"

With the above in mind. I will tell the real life example of the scenario.

I have a LONG stock strategy that generates signals that gives + and - profits.
My intial goal is to improve this stock strategy results, by using protective PUT options.
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Real life example of a signal to isolate the Question:

Step 1:
Buy 100 shares of stock IBM at 100 dollar on 1 september.
Buy 1 PUT at strike price 99.5 dollar (Price/Premium for the PUT is 0.5 dollar)
Step 2:
On 2 september. IBM has hit the price 95 dollar which is a 5% loss in the stock.
My stock strategy would now say to exit this signal and take the 5% loss.
__________________________________________________________________

Question 1:
Can we agree in Step 1 that strike price + premium for option in reality means a
maximum loss that can occur for the stock position is 1% ?
(((100 - 99.5) / 100) * 100) + ((0.5 / 100) * 100) = 1%

Question 2:
This is the main question. On 2 september when the stock is down 5% my idéa here is to limit this loss with my protective PUT. As my stock strategy says it is time to exit this signal, what I would want to do is to EXERCISE my PUT at strike price 99.5 dollar which in my head right now would mean that our loss only will be the 1% and not 5%.
So I don´t want to wait for the PUT option to expire on for example the 20 september as that would mean that I still would need to own those 100 IBM shares until that date.

I wonder what I am thinking correct here and what I am missing out, if I am missing anything out?

Regards

 

[Martinghoul]

1. Yes
2. Yes, you can do this, in theory.

The problem with all of your conjectures above is that your starting point is just not realistic. There is no free lunch. There is simply no way in hell that you will be able to buy a 99.5 strike put with any meaningful time to expiry for $0.50. A put like this would be a LOT more expensive (indeed, why would anyone sell you an option for just intrinsic value). A further implication of this is that, if/when the price of the option you paid includes some time value, it becomes uneconomic to exercise the option early.

Again, there ain't no free lunch.

 

[scaft]

Please ignore as much as possible the price/premium of the option if possible, I know it is more expensive. I should have written something else there.

>> A further implication of this is that, if/when the price of the option you paid includes some time value, it becomes uneconomic to exercise the option early.

I think this is exactly what I don´t understand. How can we understand what this means exactly. What is the uneconomic thing refering to my example?
Let us assume that we exercise the option on the 2 September. What would be the uneconomic thing here. I beleive some kind of formula is needed here to see very clearly what is happening in the mathematical sense?

 

[Martinghoul]

Please ignore as much as possible the price/premium of the option if possible, I know it is more expensive. I should have written something else there.

>> A further implication of this is that, if/when the price of the option you paid includes some time value, it becomes uneconomic to exercise the option early.

I think this is exactly what I don´t understand. How can we understand what this means exactly. What is the uneconomic thing refering to my example?
Let us assume that we exercise the option on the 2 September. What would be the uneconomic thing here. I beleive some kind of formula is needed here to see very clearly what is happening in the mathematical sense?

Well, that's exactly my point... If you want to talk about what's uneconomic about the early exercise, you need to talk about the actual realistic prices for the options in question. Realistically, option prices include a time value component. When you exercise early, you're effectively giving up the time value of the option for free.

Now, generally speaking, it is occasionally optimal to do this, due to the interest that you receive on the cash proceeds from the sale (the argument is that early exercise is optimal if expected interest income is worth more than the time value remaining in the option). I very much doubt that the case you describe fits the description above.

 

[scaft]

It is true, I have got the current values that should be quite accurate to take as an example.

If I understand correct regarding the time value. Is the below a correct formula to see if it is
economical to exercise the PUT option early.

Question 1:
Strike price: 195.00 Bid price: 4.40
Current stock price: 190.00

If below statement is true as it is below, the early exercise is in this case economical?
strike price - current stock price > Bid price of Put option
195 - 190 > 4.4

Question 2:
SELL the PUT is the same thing as Exercise the PUT?

Question 3:
If it would not be economical. This would mean that we have to keep the 100 IBM shares on the account until the expiration happens for example?

If that is true. Is there any method where I SELL the shares as a stock order. Reason is to liquidate the cash to for example invest in any other stock, - and keeping the PUT option until expiration to indirect receive the same result.
At first that doesn´t seem as a good idéa as I will need to pay 2 extra courtages.
(Sell a stock order) PUT option will short 100 shares where I need to (Buy a stock order) to get flat.
Also at that time the stock will likely be at another price level which makes that wrong.
I am not sure here if you can understand what I mean as an example and simply wonder if there could be any method to get rid of the stocks and keeping the PUT to achieve the same results?

 

[Martinghoul]

1. Well, it doesn't really make a lot of sense to look at options with 1 day to expiry, generally. They have virtually no time value. So why don't we look at the 27Sep2013 expiry puts instead.

IBM 27Sep2013 expiry 195 puts are 5.00/5.25 market, with IBM trading at 190.32/190.40. For this put, intrinsic value is 4.64 (using mids) and, therefore, time value is 0.485.

So your rule is sorta redundant. If the put is worth less than its intrinsic value, it's definitely optimal to exercise. However, this just doesn't happen in practice.

2. No, selling the put isn't the same thing as exercising the put. Look at the example I have given above (the 27Sep13 expiry option) and you will see the difference.

3. No, I don't quite see exactly what you mean. My point is that systematically buying shares with a protective put is not a positive expectation exercise. The puts don't offer you the ability to buy the shares of the underlying with impunity. Moreover, I am a little confused at how your strategy has gone from revolving arnd buying the stock with limited downside to playing with the puts.

 

[scaft]

>> No, I don't quite see exactly what you mean. My point is that systematically buying shares with a protective put is not a positive expectation exercise. The puts don't offer you the ability to buy the shares of the underlying with impunity. Moreover, I am a little confused at how your strategy has gone from revolving arnd buying the stock with limited downside to playing with the puts

Yes, I am very new to options so I am trying to figure out how it works and what could be a good practise.
As you say, that having a normal stock strategy that buys shares and using puts systematically isn´t a positive way.
For example in the stock strategy, I set a stoploss to be 5 % but in reality that is not the case since GAPS will occur sometimes. In a few cases, we can have a negative results for -30% or more. This do happens as I have the ability to backtest.
Reason that options came to my mind is to protect against when those rare occasions actually will happen.
As per the strategy, it would be long trend following where we keep the stock between 1 day to 3 weeks or so.

Perheps I am way off using options in a scenario like this?

 

[Martinghoul]

No, you're 100% correct in looking at options. In fact, one of the greatest reasons why options have value is something that isn't often mentioned: liquidity. In a mkt where gaps can occur, options offer you protection. Problem is that this protection isn't free. So the question for your strategy then becomes rather more complicated. Specifically, let's say your strategy provides you a stable return of X with some volatility characteristics (for simplicity, max drawdown of Y). "Enhancing" your strategy with protective puts will lower your expected return (since you will have to pay for the puts), but will also lower your max drawdown. Ultimately, you have to make a judgement whether the tradeoff like that appeals to you.

 

[scaft]

Yes, I wan´t to really understand when options can be of value as you explain.

I will tell how I trade as it is quite extreme to really overlook if options perheps wont help so much or wont be as important. I am just a bit extreme and doesn´t want anything go to waste.
I have my software with very complex reports and drawdowns as you say is a very important result to look at.
When I runned some tests (theoritical values) options would have improved the strategies. But however, now when I have learned how it practially works, it was not that easy as you have learned me.

As I am striving to not enter a position with more than 3-4 % of the total capital as this greatly reduces drawdowns in the reports.
For example if we do have this -30%. That will for the whole portfolio mean a loss of ca 1% etc.

No, you're 100% correct in looking at options. In fact, one of the greatest reasons why options have value is something that isn't often mentioned: liquidity. In a mkt where gaps can occur, options offer you protection. Problem is that this protection isn't free. So the question for your strategy then becomes rather more complicated. Specifically, let's say your strategy provides you a stable return of X with some volatility characteristics (for simplicity, max drawdown of Y). "Enhancing" your strategy with protective puts will lower your expected return (since you will have to pay for the puts), but will also lower your max drawdown. Ultimately, you have to make a judgement whether the tradeoff like that appeals to you.

 

[scaft]

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