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When to Exercise Your Puts

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Previously in Know Your Options, we’ve looked at the concept of call-put parity and specifically on the idea that the expected future price of an asset is the current market price plus the cost of carrying that asset until the future date.

In the case of equities, that cost of carry is primarily made up of the interest cost of holding the position, minus any dividends you’ll collect. To purchase a stock, you need to either borrow the money or commit cash you already have - forgoing the opportunity to earn interest on it. Either way owning stock has a cost of carry.

Conversely, selling a stock short creates a cash credit on which you can earn interest while you hold the position.

In the real world, there’s a difference between the rate you earn on credit balances and the rate you have to pay to borrow – banks and brokerage firms don’t work for free – but for simplicity in our example, we’re going to assume that the risk-free rate is the same for borrowing and lending

In the case of deep in-the-money puts, the cost of carry works against the owner of options.

If you own a put with a delta near 100, it’s going to behave almost exactly like a short position in the stock. Except that a short position in the stock pays interest (on the credit balance) and owning an option means incurring the cost of carry on the premium. So owning the put costs more than being short the stock - in two ways.

Here’s another way to think about it - thanks to call/put parity, in terms of profit and loss, there’s no difference between owning a put and 100 shares of stock or owning the call on the same strike, except that the put/stock position has an additional interest cost to own, and it might pay a dividend.

So the basic calculus for exercising equity puts is that if the cost of carry on the strike exceeds the market value of the call on the same strike, you should exercise the put.

The time when this is most likely is right after the stock trades ex-dividend (if the stock pays a dividend.)

 

 


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