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.

“I never recommend a trade”, Mark D. Wolfinger

Mark D. Wolfinger is an experienced options trader who kindly offers his expertise to others.  His blog, Options for Rookies, has excellent advice about buying and selling options, including information on doing spreads like condors and collars–strategies I don’t use because I am a seller of put options.

Recently, he has made the following comment on his blog about recommending trades, which applies not just to options but also to all trading:

As you know, I NEVER recommend a trade. That violates one of my core beliefs:

When someone sells a trade recommendation, the advice seller probably believes the trade will be profitable. However, ultimate profitability is not only dependent on the trade chose, but also depends on how it is managed. That salesman may be able to turn a profit, but that does not mean that you would. Your pain threshold is lower and there would be many instances in which you exit with a loss and he holds and earns a profit.

He claims a profit for his followers and all you see is a loss. Do you understand why that happens?

Each trader has his/her own comfort zone, trading goals and the ability to withstand a loss. Each would exit the trade at a different time. Each is at a specific point in life – perhaps raising a young family or retired. Perhaps wealthy or struggling. No one who understands trading would suggest the same trade to every person. Yet, that’s what these gurus do.

The post in which these lines are found is called, “Risk Management for the Small Trader” in which he recommends that options trader have a minimum of $10,000 trading cash and preferably twice that amount because the newbie with $5000 or less will have just enough cash to enter positions but insufficient cash to manage them well.

His advice about the management of trades applies also to stocks.  If new traders, who enter a stock with the hope that it goes up quickly, sell  it when it goes down 15%, they will likely lose that cash forever.  If they average down, and I believe in such a strategy, then they will be much less likely to lose money as a trader–even the black swan event of the market drop of 2008-2009 could have been overcome with a strategy of averaging down on losing positions.  But alas, if you have only a limited amount of cash, then that strategy won’t work, because you shoot your wad in the first instance, and there’s nothing left with which to average down.

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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The April USA deficit and buying gold

The Obama administration borrowed $82.69 billion in April, 2010.  That’s about $8.90 per day per every man, woman and child in the USA.  In my humble conservative opinion, such deficits have led and will lead to the devaluing of the US dollar, particularly because the Federal Reserve is keeping interest rates at artificially low levels.

What is the investor to do?

Gold hit a new high $1241.25 yesterday.  Gold may decline in the short term but it is experiencing a secular bull market because of the inflation of all paper currencies.  I don’t buy gold because I don’t have a safe place to store it and I don’t want to pay an army to guard it.  I’ve instead traded gold mining stocks.  At my discount brokerage, the commissions are lower than for buying and selling gold bullion or coins.   I’ve had a lot of success averaging down and selling off a little at a time as the prices improve.  My best buy was WGI (Western Goldfields), which later became NGD (New Gold), on October 23, 2008, at 88 cents; my ngd is up 183% over my average cost price.

In the last few weeks, since I learned about trading options, I’ve been selling near the money put options of abx and gg (Oct, Jan’11, Jan’12 contracts). If current trends continue, these contracts will all expire worthless (even the ABX put Jan’12 at $45) and I will simply keep the premiums.  When doing this, it is important to reserve sufficient cash or credit to buy the stock at the strike price.  But even if assigned, the purchase of the shares becomes part of the averaging down strategy.  So for example, the $45 January 2012 put on Barrick Gold paid me $8.90 premium.  The average cost price (after commissions) of the shares if assigned then is $36.29–a 22% discount off the current $46 market price.