Buying back and rolling over near but in-the-money puts just before expiration

Option contracts have two kinds of value, time value and intrinsic value.  On the last day before expiration, a put seller has a few possibilities for dealing with near but in the money puts.  By afternoon, the put contract has only intrinsic value and time value has fallen to nothing.

A person can do the following:  (1) do nothing and accept assignment; (2) buy back and take a new position with more time value.  I had the following two experiences:

The PWE (Pennwest Energy) June $23 was near the money, but as long as it was within a few cents, the price to buy to close remained 10-15 cents.  But when the price of the underlying dropped to $22.75, I was able to buy back the put at 25 cents plus commission 2.7 cents; and then sold the October 23 at 2.273 after commission.  So I cleared roughly $2.00 per share by rolling over and I never received assignment.  The assignment would have been 6.1 cents per share, so that the two commissions of 2.7 cents were less than the commission at assignment.  So that was a consideration.  But then, if I waited until after assignment for the shares to go above $23, I figured that the PWE October $23 would lose also a little time value and little intrinsic value–though this could depend on other factors such as implied volatility.

The PGH (Pengrowth Energy) July $13 put was about to expired in near money.  Last week I was a volunteer our church’s Vacation Bible Camp, and I came home on Friday morning to deal with it.  First, I wanted to sell an January $13 put to replace it, then buy back the expiring put.  But when I used the Questrade platform I made the mistake of buying a put instead of selling.  It is a new platform for me, and I was being a little careless.  But all of these DIY platforms default to a certain option, and so you must physically change it if you do not want “to buy open”.  I think that there should be no default option, but the programmers never talk to traders, I guess.  Immediate panic set in and it took me two tries to sell these back (as I didn’t put in the correct number of shares the first time) but finally at a loss of only 6 cents per share (including three commissions!) I was able to exit a position that I never intended to hold.  At that point I had no more time and I had to return to the camp.  In the afternoon, before market close, I went to buy back my July $13 put, but the underlying (PGH) was at $12.75 and had therefore 25 cents intrinsic value, but the ask price was 40 cents.  Unwilling to pay 15 cents above intrinsic value, I let it expire and took assignment.  Then, two trading days later I sold my shares at $13.05, which provided me a small profit after all commissions (2.35 cents).  I then sold a PGH January $13 put $1.185.  Now on Friday, I probably could have sold the same put at $1.335, so that the difference between what I got on Tuesday and what I would have gotten on Friday was 15 cents (including all commissions).  This seems the same as my loss on Friday had I rolled it over then, but it has to be remember that (1) I would have paid 3.5 cents commissions to roll it over that day, and I made 2.35 cents profit on selling the assigned shares.  So I saved 5.85 cents which almost pays for the 6 cent blunder that I made.  So the net profit was 1.185+.0235-.06 (blunder)=$1.149.  On Friday, I figured that I could have only cleared as much as $1.15 before commissions so I was happy with how it finally played out.  So it was a wash in the end, despite my careless trading on Friday.

So I guess the lesson in these two scenarios is that it is good to buy back an option on expiry if you can get it for intrinsic value.  The commission cost on assignment would easily offset the commission costs of buying back and selling the new position.  But if market will not sell at intrinsic value, it is probably just as well to take your chances with assignment, particularly if you are still bullish on the underlying security.  The advantage of PGH is that it’s 7% monthly dividend would have more than paid margin interest charges–so even if it takes months for it to return to the strike price, you are able to cover all the carry charges.

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Rolling over puts: when to buy to close a put option

I use the following spread sheet to determine when and whether to buy back a put option (please note that commissions are calculated into the costs and original premium):

expiry symbol market strike # Current
premium
comm cost original
premium
gain/
loss
% gain/
loss
days at
start
days
remaing
time
remaining
composite
Jan 2012 abx $47.02 $45.00 3 $5.95 $13.74 $1,798.74 $2,656.21 $8.85 $857.47 32.28% 620 446 71.94% 104.22%

The number in red is the price to buy back the option, and $857.47 is the difference between the original premium and the cost to close.  The composite number in the last column is the percent gain or loss plus the percent of time remaining.  When that number is at 100% the buy back is neutral.  You neither win nor lose on the contract.  If the number is negative, I would normally not buy back the option for I would sooner take possession of the underlying upon expiry–I should be comfortable owning the position in the underlying or I wouldn’t be selling the put option in the first place.  If the final number is above 100% then buying back the put can be done without disadvantage, because the time decay and percent of gain still add up to 100% as on the day the put was sold.  Here are the circumstances I use to buy to close:

(1) Buy to close a put if the composite number adds up to over about 135%.  This means that the premium has plummeted because the underlying has increased rapidly in market price.  At this point it becomes interesting to buy back and realize fast gains and then use the margin value to sell another put.  Gains can be multiplied by doing this.  So for example, I sold 2 puts on RY and bought it back 8 days later as such:

apr 2011 ry $45.00 2 $2.55 $12.49 $522.49 $827.49 $4.14 $305.00 36.86% 233 225 96.57% 133.42%

Less than four percent of the time had passedt, and yet there was 36.9% gain on the position.  The composite was at a very nice 133% and I didn’t have to wait another 225 days to re-risk the capital, which I used in turn to sell a put on PWE:

Mar 2011 pwe $21.43 $19.00 5 $0.70 $16.24 $366.24 983.74 $1.97 $617.50 62.77% 197 161 81.73% 144.50%

The composite number was an astounding 144.5% after only 36 days.  I repurchased the put.  Thus, the total realized gain over $305 + 617.50 = $922.50/$9500 (captial at risk)= 9.7% gain in a period of 44 days, which represents a 80% annualized gain.  This shows how it can be lucrative to buy back a put option.

(2) Buy to close a put when it only costs about $50 and there is more than about 60 days remaining.  Since most of the original premiums for me are in the $700 – $1000 range, it makes sense to buy back something that has so much time left on it but costs so little to buy back–less than $1 per day.  When its more than $1 per day, it’s probably better to let it expire worthless.

(3) Buy to close a put after losing confidence in the underlying.  TA was downgraded at TD Waterhouse and Scotia Capital.  I bought back the position as follows:

dec 2010 ta $21.00 $20.00 5 $0.26 $16.24 $146.24 $508.76 $1.02 $362.52 71.26% 232 88 37.93% 109.19%

The composite number was still at an advantage to me, but I had lost confidence in the underlying and did not want to take the position if the put expired in the money.  I still came out ahead on this one by $362.52.

So far these are the guidelines that I use to buy to close put options and would appreciate any pointers or questions that people might have to make in the comments.