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When is a Call Really a Put (Part 2) - Mailbag Edition

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I received the following email from a Zacks Customer:


I was reading David Borun’s article today: https://www.zacks.com/commentary/168395/when-is-a-call-really-a-put and was intrigued by his statement, “it’s just as if we owned the put for free.”
I own 2 NFLX call options w/ a strike price of $200 w/ an expiration date of Jan 18, 2019.  This position is up ~700%.   What is David’s recommended exit strategy to maximize potential profits while locking in my current earnings?
Cheers,
Christopher


This is a good real-world example of an options position that has worked very well and now affords the trader some choices about how best to close it. It’s also a good teaching moment because it’s basically the same concept that we discussed last week in which we used short-term options as an example, but with a few additional aspects to consider because there is much more time to expiration.


Read Last Week’s Article Here>>


So in this case, I’m going to infer that Christopher purchased the options for $28 each at least six months ago when Netflix (NFLX - Free Report) was trading closer to $200/share. (So, first of all, Christopher – nice trade. You caught one of the great bull runs in a stock this year.)


Here are the closing prices from Tuesday June 26th for the securities involved:

                                         Bid                       Ask
NFLX                                399.30                 399.50
JAN19 200 Call                 203.50                 205.50
JAN19 200 Put                 1.72                     1.92


At this point, the 200 call is so deeply in the money that it has a 97 delta. For every dollar the underlying stock moves up or down, the call will move 97 cents. So being long two of the 200 calls is functionally the same position as owning 200 shares of the stock, but with some downside protection. If the stock continues to rally, the holder of the calls will participate essentially the same as someone who owns 200 shares, but if the price were to fall considerably, the delta of the calls will be incrementally reduced and the calls will lose less value than the shares as they decline.


If NFLX traded $300/share tomorrow, the 200 calls would have an approximately 85 delta, and at $200/share they would have a 50 delta.


The maximum loss on the position from this point is the entire current value of the calls – or $203.50 each, whereas the stock could theoretically lose its entire value - $399.30.


P/L profile for the stock:



P/L Profile for owning 2 200 calls:



One more thing to note, NFLX does not pay a dividend, but if it did, the holder of call options does not receive it while shareholders do. So in dividend paying stocks, holding deep in-the-money calls is not exactly the same as owning shares.


So building on the examples from last week’s article, Christopher has some choices.


Sell the Calls


If he sells the calls on the bid, he will lock in approximately $175 per option in profits and will have no position at all going forward. You’ll notice that even on the market bid price, the premium to be gained is greater than the sum of the amount the call is in the money (its intrinsic value - $199.30) plus the value of the put on the same strike ($1.72). This is because there’s an extra bit of premium on a long-term call because of interest, which will be discussed below.


Selling the calls is the simplest way to close the trade and collect the profit you’ve made. But there’s one caveat. Notice that the bad/ask spread for the calls is $2 wide. If you simply sell the call on the bid, you’re giving up a dollar or more of the intrinsic value. A smarter order would be to offer the call near the middle of the market. Electronic market makers are always on the lookout to buy deep in the money options at a discount to the market, but don’t continuously post those bids. With such a wide market – while the bid ask spread in the stock is $0.20 wide, you’re likely to get filled at a higher price on the options if you try in the middle, especially if it’s a small number of options.


Or you could simply put in a resting offer above the current market and if the stock continues to rally, you’ll get filled later.


Sell Stock


If Christopher sells 200 shares of stock at $399.30, he will lock in $171.30 in profit per option and he will have no further potential for upside appreciation, but he will essentially own two 200 strike puts.  If the stock stays above $200/share until expiration, he will buy back the shares he’s short by exercising the options, but if the stock were to be lower than $200, he would not exercise the calls and buy the stock in the open market instead, increasing his profits.


This is what I meant by “owning the puts for free.”


Interest Earnings


Here’s why this situation is a little different than when we were discussing very short term options. The approximately $40,000 in market value that Christopher currently has in these calls pays no interest. If he sells the calls now, he will have that $40K in his account where it will earn interest. If he leaves it there until the options would have expired in January, assuming an interest rate of 1.5%*, that money will earn an additional $336.


$40,000 X 205/365 X 0.015 = $336


If he sells 200 shares instead of selling the calls, Christopher will have a credit balance of $80,000 from the sale that will earn interest until the options expire, providing an additional $672 in income.


Partial Closing Trade


There’s no reason the trade has to be closed all at once. Professional traders routinely “scale” into or out of positions with several trades rather than opening or closing all at a single price. If Christopher is still cautiously bullish on NFLX, he could sell one of the calls, lock in half the profits and keep the other open. Or he could also sell 100 shares instead of the whole 200.


Here’s a recent Zacks article about Netflix’ share price >>


Conclusion


The deep-in-the money call position that results from a successful call option purchase will basically act like a long position in the stock.  So if the original bullish thesis that convinced you to initiate the trade in the first place is still intact, you could choose to simply stay long the calls.


With such a tremendously successful trade, the most disciplined approach is probably to take at least some of the profits off the table.


And if the trade has succeeded beyond your wildest dreams and you have no opinion on the likely direction of the stock over the next 7 months, it’s probably time to close it down (by either selling the calls or the shares) and move on to the next trade.




*1.5% annually is the interest rate implied by these options prices. (The interest charged or credited at individual brokerage firms will vary. Contact your brokerage to confirm the rates they charge/pay before making trades based on interest costs.) Here’s how to calculate it:


If you take the midpoints of the bid ask spread for each instrument and plug them into the call/put parity equation - Call-Put+Strike = Future, you get:


204.50 – 1.82  + 200 = 402.68


So the implied futures price of the stock is $402.68. The midpoint of the stock-bid ask is $399.40, so the future has $3.28 in premium, implying that it would cost $3.28 to carry $399.40 worth of stock for 205 days until the options expire. Since cost of carry is the interest cost minus any dividends received - and NFLX does not pay a dividend - the entire $3.28 represents interest cost.


(Premium/Stock Price) / (Days Remaining/365) = Implied Interest Rate


(3.28/399.40) / (205/365) = 0.0146 - or an implied annual interest rate of 1.5%.

 

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