Buying "Deep in the money" options

[Value Collector]

Hi Guys,

I am far from a guru when it comes to options, I run a pretty simply operation selling puts and sometimes using a "buy write call option" strategy.

But I occasionally see bids in the market for very deep in the money puts.

For example today I saw a bid for an FMG March 2018 put with a strike of $8.50, for $2.86

I was just wondering if anyone had an idea of what sort of strategy that buyer could be using.

It seems to me that he is willing to put up $2.86 today, in the hope the fmg share price drops below $5.64.

But couldn't he achieve the same effect with an option that is not as deep in the money, and then not have to put up so much capital?

I must be missing something.

 

[Sharkman]

might have wanted to just make a short bet with a built in guaranteed stop loss.

nearer the money it'll cost more decay to get the same amount of deltas. especially for a seriously volatile stock like FMG whose IV has to be pushing 60 (if not even higher).

assuming a stock price of $6, 100 contracts of the 8.50 puts gets around -7000 deltas and costs $3,600 in extrinsic.

to get those same -7000 deltas using the $6 puts would need about 170 contracts which would cost approx $20K in extrinsic (pretty much the entire thing would be extrinsic in this case).

plus there is also delta skew to take into account - the $8.50 puts would almost certainly be cheaper (in IV terms) than the $6 puts.

 

[Value Collector]

might have wanted to just make a short bet with a built in guaranteed stop loss.

nearer the money it'll cost more decay to get the same amount of deltas. especially for a seriously volatile stock like FMG whose IV has to be pushing 60 (if not even higher).

assuming a stock price of $6, 100 contracts of the 8.50 puts gets around -7000 deltas and costs $3,600 in extrinsic.

to get those same -7000 deltas using the $6 puts would need about 170 contracts which would cost approx $20K in extrinsic (pretty much the entire thing would be extrinsic in this case).

plus there is also delta skew to take into account - the $8.50 puts would almost certainly be cheaper (in IV terms) than the $6 puts.

Yeah I did notice that the at the money puts were selling at premiums that would make the break even point lower than the $5.64 break even on the $8.50 put.

So I guess that might be the reason, but the negatives to that are.

1, they had to put up more capital, so they lose the interest they could have earned on the capital in the mean time.

2, the have a lot more risk associated with the stock rising, if the stock ran up, it could quickly eat into that big chunk of capital they had to use to buy the option.

I ended up selling 100 contracts, because as you can see in the FMG thread I am fairly bullish on FMG, and wouldn't mind owning the stock for $5.64, plus in the mean time I can earn interest on the $28k premium, and I have exposure for any upside to the $8.50 strike price.

Basically, it's like I have bought the stock and will get the benefit of any upward movement to the $8.50 strike as if I owned it, without actually having to outlay money upfront to buy it, and instead will get to earn interest on the $28k premium.

 

[Warriortrader]

Hi Guys,

I was just wondering if anyone had an idea of what sort of strategy that buyer could be using.

They could be buying options deeper in the money to define the risk of their short positions. So a Credit Spread could have a Short OTM position and a Long ITM position.

 

[Sharkman]

1, they had to put up more capital, so they lose the interest they could have earned on the capital in the mean time.

if his primary goal was to get short delta, and he wasn't too concerned about trading gamma/vega, his other alternative would have been to short the stock outright and that would likely have cost him more interest.

vs the $6 puts, the $8.50 puts do require more capital outlay but with the ridiculously high IV of FMG, he may have been more concerned about reducing the time decay he was paying rather than the foregone interest.

2, the have a lot more risk associated with the stock rising, if the stock ran up, it could quickly eat into that big chunk of capital they had to use to buy the option.

true, but if the stock doesn't move much the decay being paid on the (larger volume of) $6 puts will mount up much more quickly.

I ended up selling 100 contracts, because as you can see in the FMG thread I am fairly bullish on FMG, and wouldn't mind owning the stock for $5.64, plus in the mean time I can earn interest on the $28k premium, and I have exposure for any upside to the $8.50 strike price.

Basically, it's like I have bought the stock and will get the benefit of any upward movement to the $8.50 strike as if I owned it, without actually having to outlay money upfront to buy it, and instead will get to earn interest on the $28k premium.

that's already been factored into the option price, risk free rate is one of the inputs into black/scholes (and many other) pricing models. eg. the $8.50 calls (assuming identical IV) should have been around 42c (vs the 36c of extrinsic that you got), because the call buyer gets the same amount of delta exposure as if he was holding the stock, but he doesn't have to make the capital outlay for the stock up front, so his capital is sitting there earning interest in the meanwhile. the pricing models will factor that in and make him pay more extrinsic for those deltas.

in other words if interest rates were 0%, the $8.50 calls should be around 39c and you would've received about 2.89 for those $8.50 puts.

also remember that you are short options, so your broker will likely withhold some of your capital (which could be more than the premium you took in) to act as collateral for that short position, which cannot be used to open other positions in the meantime whilst you are short those puts. depending on how conservative the broker is, that could very well be the full 85K that you will have to stump up if you get assigned on those puts.

 

[Value Collector]

also remember that you are short options, so your broker will likely withhold some of your capital (which could be more than the premium you took in) to act as collateral for that short position, which cannot be used to open other positions in the meantime whilst you are short those puts. depending on how conservative the broker is, that could very well be the full 85K that you will have to stump up if you get assigned on those puts.

Nah, I have a pretty large portfolio of longterm shares that I use as collateral, so 100% of the option premiums get paid to me in cash, the $28K will go into my bank account at 3pm and be offsetting my home loan interest right away.

So I have three possible outcomes.

1, In march the shares at break even e.g. $5.64 = I got home loan reduced by $28K for 7 months saving interest.

2, In march shares are below $5.64 = I get shares at $5.64, earning 8.8% dividend, and saved some home loan interest.

3, In march shares are above $5.64 = I get $28K loan for 7 months + $100 for every 1 cent the share price is above the breakeven of $5.64.


I am pretty happy with any of those outcomes.

 

[Value Hunter]

Value Collector you should add option 4) The share price of Fortescue Metals falls well below $5.64 e.g. to $4 off the back of operational issues or a fall in Iron ore prices which result in falling earnings and dividends. The additional shares you purchased at $5.64 are also underwater so to speak. The earnings and dividends (divvies could even be cut in a downturn) of Fortescue remains depressed for a long time due to Iron ore price weakness. For what its worth I do not think this scenario is likely but its still possible. Its notoriously difficult to invest in cyclical stocks.

 

[Value Collector]

Value Collector you should add option 4) The share price of Fortescue Metals falls well below $5.64 e.g. to $4 off the back of operational issues or a fall in Iron ore prices which result in falling earnings and dividends. The additional shares you purchased at $5.64 are also underwater so to speak. The earnings and dividends (divvies could even be cut in a downturn) of Fortescue remains depressed for a long time due to Iron ore price weakness. For what its worth I do not think this scenario is likely but its still possible. Its notoriously difficult to invest in cyclical stocks.

Yeah, but obviously I don't think that's going to happen.

And buying the shares directly at market price today doesn't eliminate that risk, it would be more risk, given that I would be losing money from $6, instead of $5.64, I would have to outlay my capital upfront today rather than in 6 months, and wouldn't have the $28k loan for 7 months.