38 lines
2.8 KiB
Plaintext
38 lines
2.8 KiB
Plaintext
Accepting Exposure • 223
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they own rather than trade them away for a profit. Recall from Chapter 2
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that experienced option investors do not do this most of the time; they
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know that because of the existence of time value, it is usually more beneficial
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for them to sell their option in the market and use the proceeds to buy the stock
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if they want to hold the underlying. Inexperienced investors, however, often are
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not conscious of the time-value nuance and sometimes elect to exercise their
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option. In this case, the exchange randomly pairs the option holders who wish
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to exercise with an option seller who has promised to sell at that exercise price.
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There is one case in which a sophisticated investor might chose to
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exercise an ITM call option early, related to a principle in option pricing
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called put-call parity. This rule, which was used to price options before
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advent of the BSM, simply states that a certain relationship must exist be-
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tween the price of a put at one strike price, the price of a call at that same
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strike price, and the market price of the underlying stock. Put-call parity
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is discussed in Appendix C. In this appendix, you can learn what the exact
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put-call parity rule is (it is ridiculously simple) and then see how it can be
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used to determine when it is best to exercise early in case you are long a
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call and when your short-call (spread) position is in danger of early exercise
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because of a trading strategy known as dividend arbitrage.
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The assignment process is random, but obviously, the more contracts
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you sell, the better the chance is that you will be assigned on some part or all
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of your sold contracts. Even if you hold until expiration, there is still a chance
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that you may be assigned to fulfill a contract that was exercised on settlement.
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Clearly, from the standpoint of option sale efficiency, an ATM call is the
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most sensible to sell for the same reason that a short put also was most efficient
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ATM. As such, the discussion that follows assumes that you are selling the
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ATM strike and buying back a higher strike to cover.
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In a call-spread strategy, the capital you have at risk is the difference be-
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tween the two strike prices—this is the amount that must be deposited into
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margin. Depending on which strike price you use to cover, the net premium
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received differs because the cost of the covering call is cheaper the further
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OTM you cover. As the covering call becomes more and more OTM, the ratio
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of premium received to capital at risk changes. Put in these terms, it seems
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that the short-call spread is a levered strategy because leverage has to do with
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altering the capital at risk in order to change the percentage return. This con-
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trasts with the short-call spread’s mirror strategy on the put side—short puts—
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in that the short-put strategy is unlevered. |