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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Answering Questions about selling puts and revealing a strategy

An investor friend has asked me some questions about the selling of put options.  His questions are in bold italics.

When you sell puts, do you have to cover the dividend distribution for the buyer? No.  You don’t own the stock.  You have sold an obligation to buy the stock at the strike price –at a random buyer’s discretion–the contracts are fungible, so assignment is an entirely random process (especially early assignment, which is very rare).  The dividend belongs to those who have open contracts on the other end (they bought the put as an insurance and they are holding the underlying).  If I am assigned the stock before the ex-dividend date the dividend is mine.  If it is after, the dividend belongs to the buyer of the put.  Regular dividends are calculated into the price of the premium, according to the experts.  But extraordinary dividends are considered part of the strike price (i.e., a $3 dividend for Microsoft, would mean that on the day of expiry if Microsoft was $25 and the strike price was 29, the $3 extraordinary dividend would be added to the 25 and the contract would expire in the money.  If assigned, the buyer would relinquish 100 shares and $300.

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Petrobank spinoff II: What happens to an option contract?

In a previous post, I wondered what happens to an options contract after a spinoff. Petrobank spun off Petrominerales–its Columbian holdings.  I figured, based on the rules, that if my puts were assigned I would receive 100 shares of Petrobank and 61.5 shares of Petrominerales, and then learned that the Montreal Stock Exchange confirmed my analysis.

Saturday the January contract expired.  PBG closed at $23.38 and PMG at $37.27; thus the closing price for the underlying  = 23.38 +37.27*0.615=$46.30.  Well, a newbie in the backroom of the options desk at my brokerage decided my January $42 was in the money and exercised my contracts, charging me the $42 per share of Petrobank plus a $43 commission.   Obviously, Petrobank at $23.38 was deep in the money, right?  $23.38 is a lot less than $42.00.   This is the note in my activity (with amounts whited out):

Apparently, not everyone in the backroom knows what she’s doing and somebody a little smarter decided that this assignment better be canceled.  I never did get my 61.5 shares of Petrominerales (per contract). But hey, guys, if you want to assign me 100 shares of PBG and 61.5 shares of PMG, I’d happily receive them for the price of 100 shares at $42.  That would be a net gain of $4.30 per share.  I’ve heard that once in a blue moon a novice options buyer will exercise an out of the money option–for the seller, this is a gift.

My final thoughts on this is that after a bit of experience, it is very possible that the DIY trader will know more about options than some of the people working the options desk at the brokerage.  When I first started out, I asked about the commission rates upon assignment/exercise–not just once but several times.  Each representative gave me a different answer: one said standard commission, others said they didn’t have any idea, others said $43–but what about multiple contracts?  No idea.  etc. etc. etc.  I finally stopped trying to get a definitive answer and just waited.  My contracts that did expire in the money were charged $43 (the DIY rate) upon assignment and this was for multiple (5) contracts in the same order.  So the actual event helped me to formulate a better cost analysis.

The long and short of it: 2010 DIY summary

Our DIY investment portfolio has had a strong performance this year.  It is very difficult to determine actual performance because of contributions of new principle, but suffice it to say that our personal wealth experienced a 25% increase since January 1, 2010.  Considering that the TSX was up 14.4% this year, I shall now claim that I beat the index in 2010, and so far since becoming a DIY investor (Nov 2005) that has been the case: the TSX is up 15.8% over the last 5 years, while we are standing at 76% unrealized gain in our current positions (plus considerable dividends and realized gains over that same period). Our net worth has nearly doubled since June 2008 (before the meltdown) and our current rate of monthly increase is at 5.5 times what it was before I became a DIY investor in 2005.  I’ve discussed on these pages the strategies that I’ve employed (see category “investment tips”).  But to summarize below:

Long:  Gold, silver, oil & gas, sugar, loonie, Canada

Short: US dollar

Best moves:  Held Midway Energy (mel), up 48%; held New Gold (ngd), up 255%.  Added Crocotta Energy (CTA), up 53%. Used leverage in US margin account to buy Canadian high yield stocks (pwe, pgh, erf, pvx, avf.un) and traded favorably in and out of these positions.  Received approval to trade options and used them to great advantage–in particular, I greatly benefited from the sale of put options on Canadian oil and gas and gold mining companies (esp. the following–Canada exchange: cpg, dgc, gg, abx, pbn, pbg, day; US exchange: gg, abx, pwe, pgh, erf and ngd).  Increased non-margin credit facility by 230%: these consist of a loan from a relative (10%), two HELOCs (80%) and a unsecured line of credit (10%).  NB: Most of this credit facility is unused and left in reserve to cover put options–this allows me to safely sell more put options and not have to worry if there is a decline in excess margin credit in the portfolio.

Worst moves: Added more Perpetual Energy (pmt), new positions down 28% (overall position is down 35.6% not counting dividends); held Prospex (psx) which went to as high as $2.52, ended year at $1.31. Natural gas: bought Terra Energy (TT–up 0%), added more pmt, psx, Pace (pce).  Sold a covered call on Detour Gold and became more bullish afterward–this resulted in a $4.49 loss to buy back the call.  Failed to pay all taxes on income trust distributions in 2009 because an unintentional oversight by myself and by my accountant–I will seek a new accountant, and I’ve decided to include an income summary with all the paper work that I provide my accountant in the future: the CRA fined me 20% (over $1000–it was nearly $3700 total notice of reassessment) because of a similar oversight in my 2008 return.  The worst part of this whole episode is the fear of being on the radar of the taxman for the next few years.

Is this a recommendation to become a DIY investor?  I don’t know but it is an apologetic, since most financial writers in the official media say that retail investors do poorly and that they can’t beat the index.  After five years of experience and after not merely surviving but thriving in a period that included one of the worst bear markets in history (September, 2008-March, 2009), I have a growing confidence that I can consistently beat the index and make better money at this than at a day job.  While I won’t give a blanket recommendation to everyone to become an DIY investor, Adam Hamilton does recommend that everyone become a trader (see Monty Pelerin).

Petrobank spinoff: what happens to an option contract? (updated)

Update 29 December 2010:  Please note that Montreal Stock Exchanged has clarified these issues in a PDF document:  the contracts are now trading under the ticker PBG1.  The value of each contract is essentially what I predicted in this post.  Each contract is now based upon the following:

100 common shares of Petrobank (PBG) and 61 common shares of New Petrominerales (PMG) and a cash portion equivalent to 0.5 common share of PMG

 

Original post:

I have sold some April puts on Petrobank.  Yesterday they announced the spinoff of their holdings in Petrominerales of which they own 60%.  According to the Globe and Mail, Petrobank holders will receive shares Petrominerales when the arrangement closes before December 31:

The subsidiary, which produces oil in Colombia, saw its shares climb by almost 7 per cent. Following the reorganization, Petrobank shareholders will receive approximately 0.62 shares of the former subsidiary, renamed New Petrominerales, for every share of Petrobank they currently own.

I’ve sold some put contracts of Petrobank, and I was wondering what happens to my options contracts in case they are in the money at expiration, since the new share price of Petrobank will obviously adjust to reflect its value after the spinoff.  I found this answer at the International Securities Commission:

Corporate actions such as mergers, acquisitions and spinoffs will often necessitate a change to the amount or name of security that is deliverable under the terms of the contract. When such adjustments occur, the short call position is responsible for delivering the adjusted security.

For example: The shareholders of company JKL Inc. have approved a takeover bid placed by Global Giant Co. As a result, holders of JKL stock will now be entitled to a 1/2 share of Global Giant for every share of JKL Inc. they own. Therefore, holders of JKL call options will now be entitled to a deliverable amount of 50 shares of Global Giant for every contract of JKL that they are long (100 shares per contract x .5 Global Giant). Investors with short positions in JKL call options would then be responsible for delivering 50 shares of Global Giant for every call option assigned.

If I am correct, if my shares are assigned, I will receive at the strike 100 shares of Petrobank for each April contract in the money; I would also receive 62 shares of New Petrominerales.  Those exercising a call contract would receive the same.  I don’t know how the  price would be calculated, but I assume the combined market price on expiry of 100 shares of Petrobank and of 62 shares of Petrominerales.  If anyone knows, please make a comment below.