parity and arbitrage

R

RainmanRam

I'm new to options and have some outstanding in the money covered calls coming due this month. I'm considering rolling the up and forward for a credit but have a timing question.

Looking at the positions, they are currently 2% of the underlying from parity. At what point do I start risking arbitrage assignment? Are there any metrics that would help time this decision? I'd imagine volitility would have to be taken into account somehow.

One position is on a $10 underlying and the other is on a $27 underlying. So the minimum bid/ask spreads come in at .5% and .2% respectively. I'd suspect the .5% would be more at risk of arbitrage but have no idea how to relate the two.

Any insights or suggestions would be welcome.

Thanks,
Ray
 
Quote from RainmanRam:

I'm new to options and have some outstanding in the money covered calls coming due this month. I'm considering rolling the up and forward for a credit but have a timing question.

Looking at the positions, they are currently 2% of the underlying from parity. At what point do I start risking arbitrage assignment? Are there any metrics that would help time this decision? I'd imagine volitility would have to be taken into account somehow.

One position is on a $10 underlying and the other is on a $27 underlying. So the minimum bid/ask spreads come in at .5% and .2% respectively. I'd suspect the .5% would be more at risk of arbitrage but have no idea how to relate the two.

Any insights or suggestions would be welcome.

Thanks,
Ray
More...

I'd love to help, but I find the lack of details so overwhelming that I simply do not understand what you are asking.

What does 'they are 2% of the underlying from parity' mean? You say the options are ITM.

Is it 2% in the money?

Is the premium over parity 2%?

What the heck is 'arbitrage assignment?'



How about this:

Ask again. Omit commentary and just provide details.
Stock price, option strike. Bid/ask if you care to supply it. What option do you want to roll into. etc

Thanks

Mark
 
CLF trading around 28.31
Short the Jun 24 call bid 4.60 ask 4.80
Thinking of rolling to the Jul 25 call bid 4.90 ask 5.10

I've seen the net credit higher than this but that's not relevant.

The Jun 24 with a bid of 4.60 is .29 from parity which is just over 1% the underlying.

As the option gets closer to parity the chance of assignment by arbitrageurs increases significantly.

Thanks,
Ray
 
Quote from RainmanRam:

CLF trading around 28.31
Short the Jun 24 call bid 4.60 ask 4.80
Thinking of rolling to the Jul 25 call bid 4.90 ask 5.10

I've seen the net credit higher than this but that's not relevant.

The Jun 24 with a bid of 4.60 is .29 from parity which is just over 1% the underlying.

As the option gets closer to parity the chance of assignment by arbitrageurs increases significantly.

Thanks,
Ray
More...

1) You are mistaken. The chances of being assigned prior to expiration remain near zero. Unless there is a dividend between now and expiration, there is no possibility that anyone with a working brain will exercise a call option sooner than necessary. And arbitrageurs have working brains.

2) If you are assigned, what's so bad? You earn the maximum profit that this investment can make.

3) If you want to roll, forget how much premium remains in the option you want to buy. For example, if the July call were trading $3 higher and the June call, $1 higher, would you refuse to buy the June call - just because the premium was 'too high'? Would you ignore the fact that you can collect $2 more for the spread?

You want to roll. How much do you want to collect for that roll? Once you know how much, then roll when you can get it and ignore the prices of the individual options.

Note that rolling continues your risk to the downside, and allowing yourself to be assigned locks in the profit. Which do you want to do? Is the profit potential sufficient to carry the risk?

Do you want to own the Jul Covered call at these prices? If yes, roll. If 'no' wait for better prices.

Those are things that should matter to you - not the premium remaining in the call you want to cover.

4) If you sell the stock via assignment, so be it. Find another stock to trade. You are not married to this one.

Mark
http://www.mdwoptions.com
 
Quote from dagnyt:

1) You are mistaken. The chances of being assigned prior to expiration remain near zero. Unless there is a dividend between now and expiration, there is no possibility that anyone with a working brain will exercise a call option sooner than necessary. And arbitrageurs have working brains.

2) If you are assigned, what's so bad? You earn the maximum profit that this investment can make.

3) If you want to roll, forget how much premium remains in the option you want to buy. For example, if the July call were trading $3 higher and the June call, $1 higher, would you refuse to buy the June call - just because the premium was 'too high'? Would you ignore the fact that you can collect $2 more for the spread?

You want to roll. How much do you want to collect for that roll? Once you know how much, then roll when you can get it and ignore the prices of the individual options.

Note that rolling continues your risk to the downside, and allowing yourself to be assigned locks in the profit. Which do you want to do? Is the profit potential sufficient to carry the risk?

Do you want to own the Jul Covered call at these prices? If yes, roll. If 'no' wait for better prices.

Those are things that should matter to you - not the premium remaining in the call you want to cover.

4) If you sell the stock via assignment, so be it. Find another stock to trade. You are not married to this one.

Mark
http://www.mdwoptions.com
More...

1) I don't think I'm mistaken. If I am than so is McMillan who also states "if the option begins to trade at parity or a discount, there arises a significant probability of exercise by arbitrageurs" ("Options as a Strategic Investment" page 83). I'd assume he means that if the option starts trading at a discount the arbitrageurs would step in and start assigning to pickup the discount.

2) Nothing. However, rolling forward has to considered as a possibility for the best use of the money going forward. Assignment might also have tax implications (wash sales).

3) Partially agree.

Your right that I should just determine what I'm willing to take for gains and enter the spread order to obtain that gain. Being new to this, I don't want to leave excess money on the table (call me greedy). Since the near term option will approach parity faster than the far term one, I thought there might be a way to determine what the optimal spread might be.

You are also right that rolling forward continues my exposure to risk but at the same time it also lowers the breakeven point by the credit received. I might not be able to obtain that breakeven point elsewhere so it should be taken into consideration.

4) Yes. I agree. However, it is often easier to keep up with a single company you are already familiar with than it is to research a new company and its options (call me lazy). Perhaps even switching to a bearish stance.

Thanks Mark. Your comments helped me to clarify my thoughts. I'll attempt to define my exact criteria for the roll and enter a spread order that meets that criteria.

- Ray
 
Note:

Its not that McMillan is wrong its just that there is no incentive for anyone to exercise the option early unless there is a dividend play. The option will NOT trade below parity.
 
Quote from RainmanRam:

Let me begin by saying I love this discussion. But, as an admitted options rookie, you are making many assumptions based on observations you have not made for yourself. You will have a much better feel for how all this works after you have been dong it for awhile.


1) I don't think I'm mistaken. If I am than so is McMillan who also states "if the option begins to trade at parity or a discount, there arises a significant probability of exercise by arbitrageurs" ("Options as a Strategic Investment" page 83). I'd assume he means that if the option starts trading at a discount the arbitrageurs would step in and start assigning to pickup the discount.

Yes, that what he meant. But, at the time he wrote the book, his statement was a HUGE error. If an arbitrageur buys the calls under parity and then sells stock short, why exercise? Simply hold the position and collect the short stock interest rebate that professionals always received. These days that rebate is much more difficult to get. But, there's still no incentive to exercise. The long call/short stock position is a FREE PUT, and why give away a FREE PUT?

If the arb buys stock and buys puts under parity, then thee is every incentive to exercise early. But not calls.

2) Nothing. However, rolling forward has to considered as a possibility for the best use of the money going forward. Assignment might also have tax implications (wash sales).

Yes. Consider it. If it's the best use of the money, by all means, roll.

If you can do better elsewhere, let the position go. If you let taxes dictate your strategies you are going to have problems. Where's the wash sale. You sell your stock and find a new investment.


3) Partially agree.

Your right that I should just determine what I'm willing to take for gains and enter the spread order to obtain that gain. Being new to this, I don't want to leave excess money on the table (call me greedy). Since the near term option will approach parity faster than the far term one, I thought there might be a way to determine what the optimal spread might be.

I do not call you greedy. I call you undereducated. Sure you can save that remaining time premium on the calls you want to cover, but who says that the implied volatility of the call you want to sell is not going to decrease? In my example, you can save that $1 extra by waiting, but you could easily lose all of the $3 extra that is currently available in the call you want to sell.

When you speak of 'leaving money on the table,' you are only looking at the option you must buy. You are ignoring the price of the option you must sell. This is a common misconception that you will have to learn for yourself.

You initiated this trade when the time premium in the option you sold was sufficient to give you a possible gain that was acceptable. What has changed? Nothing. If you can roll for your target price, or a bit higher, why wait? You can wait - and that's being greedy. Nothing wrong with waiting, but do it for the right reason - you want a higher credit for the roll. Not because the June option is priced too high.

You are also right that rolling forward continues my exposure to risk but at the same time it also lowers the breakeven point by the credit received. I might not be able to obtain that breakeven point elsewhere so it should be taken into consideration.

Forget break-even point. The first trade is OVER. Finished. Done. You won. You gained the maximum possible profit.

New trade time and decision time: Do you want to open a NEW covered call position? Do you want to write the call into which you are rolling? If yes, go for it. If not, then do not roll.

Again, looking at break-even point is the wrong approach. You may not want to believe that. it may feel strange. But it is the right way to analyze the position. The first trade is done. History.

I'm giving you a ton of great, free advice here. You don't have to agree with everything i say, but please do not dismiss it sans giving a thorough thinking.

4) Yes. I agree. However, it is often easier to keep up with a single company you are already familiar with than it is to research a new company and its options (call me lazy). Perhaps even switching to a bearish stance.

I agree completely. But the question remains: Considering that it's a company you know and it difficult to learn enough about another, do you want to roll this specific position to the new specific position for the available credit, at this time? The answer does not have to be yes.

Thanks Mark. Your comments helped me to clarify my thoughts. I'll attempt to define my exact criteria for the roll and enter a spread order that meets that criteria.

And the criteria can change as the stock price changes.

- Ray
More...

Mark
The Rookies Guide to Options
 
I'm enjoying the conversation as well. Thanks for taking the time Mark.

I am definitely a rookie and have learned a lot over the last month just by watching my positions. This discussion is very thought provoking for me and it will not be dismissed without thought. Why ask a question if you don't want to hear the answer? I realize I have a lot to learn and that will keep me asking questions.

You know what they say about free advise though...
:D

I'm kidding of course. I highly appreciate it.

There is (and I have) a lot to learn about options and how to best take advantage of them. I've said before that this forum is a valuable resource and this discussion reinforces that.

- Ray
 
Quote from xflat2186:

Note:

Its not that McMillan is wrong its just that there is no incentive for anyone to exercise the option early unless there is a dividend play. The option will NOT trade below parity.
More...

Wrong.

"It can be proved under essentially the same weak assumptions that
the above put-call parity relation does not hold for American-style
options. Here is a rough outline of the proof.

Consider the case of a non-dividend paying
stock and a strictly positive interest rate.
Then, a similar arbitrage argument to the above shows that for a
european-style call option with price c, it must be true that c > max[0, S - K e^(-r T)].
Since an American-style call C is always worth at least as much, C >= c > S - K.
But if C > S - K, then the option will never be exercised, so C = c.
That is, an American call has the same value as a
Euro-style call when there are no dividends and early exercise for it is
never optimal.

But, under the same circumstances, things are quite different for the put.
An American-style put is worth strictly more than
its Euro-style counter-part. To prove it, assume otherwise. Then,
since a perpetual Euro-style put is easily shown to be worth zero,
a perpetual American-style put must be worth zero.
But this is a nonsense conclusion since an American style put must not decrease
in value as the time to expiration increases. The premise must have
been wrong, so under a no-dividend assumption, the American-style put value P is
strictly greater the Euro-style value p. Hence P > p = C - S + K e^(-r T).
In words, the American-style put value is *strictly larger* than the value given
by the put-call parity relation. For more details see:
R.C. Merton, "Theory of Rational Option Pricing",
(Bell J. of Economics and Mgt. Science, 4, 1973, 141-183.)

And,

"The relation doesn't hold for American-style options, which
allow an early exercise prior to expiration. For example, one
of the options legs in the conversion trade may disappear
prior to expiration because of an exercise/assignment. Closing
the whole trade at this point produces a gain/loss that is
unknown when the conversion is initiated.
Not closing the trade leaves a risky position. "


So, there is no call put parity for american style options.
 
"Its not that McMillan is wrong its just that there is no incentive for anyone to exercise the option early unless there is a dividend play. The option will NOT trade below parity."

Are you only talking about calls? I've had short puts exercised against me with months left on them.
 
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