You're Giving Free Money to Market Makers Every Time You Close an ITM Option. Here's How to Stop.

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When shorting a put, the trader should aim to buy back the option at or near the intrinsic value to minimize losses. The intrinsic value of the 310 put at a stock price of 298 is 11.75. The trader should avoid buying back the option below this value, as it would result in a loss. The extrinsic value of the option is minimal, so the trader should focus on the intrinsic value when executing the trade.

310 put

If a trader is short a 310 put and cannot close the position at intrinsic value plus extrinsic value, they can exit by creating a synthetic long put. This involves shorting the stock and buying the 310 call for a penny. The goal is to close the position at intrinsic value plus a penny, avoiding unnecessary slippage and commissions. If the price exceeds 12.80, the trader should consider closing the position to avoid further losses.

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The trader can create a synthetic put by buying the stock at a low price and selling an out-of-the-money call. This locks in the intrinsic value of the put and minimizes delta risk. If the stock price moves up, the call may be exercised, resulting in a loss, but the trader can avoid significant losses by locking in the intrinsic value. This strategy is suitable for short-term trading with approaching expiration.

Reducing Slippage in In-the-Money Options

Reducing slippage when closing in-the-money options is crucial for minimizing cost and maximizing returns. The bid-ask spreads for in-the-money options tend to widen, especially in less liquid stocks, making it harder to execute trades at fair value. This is due to market makers hedging high delta options, which increases the spread as a form of protection. Slippage can add up over time, leading to unnecessary losses. Traders should be aware of these dynamics and plan accordingly to mitigate the impact of slippage.

Understanding Extrinsic and Intrinsic Value Relationship

The extrinsic value of an out-of-the-money call and the intrinsic value of an in-the-money put at the same strike price are almost the same. This relationship is crucial for traders to understand when managing options positions, as it helps in assessing the cost of carry and the impact of time decay on options pricing.

Option Risk Equivalence and Synthetic Positions

Understanding option risk equivalence is crucial for managing trades effectively. A synthetic long put can be created by shorting the stock and buying a call, which allows for exiting a short put position without carrying the risk of the underlying asset. This method is capital-intensive and requires a sufficient account size to manage slippage and commissions. The key is to fight for pennies in pricing to avoid unnecessary losses.

Market Maker Strategy and Intrinsic Value

Market makers profit from the difference between the intrinsic value of an option and the price at which they can buy or sell it. If a trader sells a put at a price below the intrinsic value, the market maker can buy the stock at the current price, exercise the put, and sell it at the strike price, capturing the difference. This highlights the importance of understanding intrinsic value and avoiding selling options below it to prevent market makers from profiting at the trader's expense.

Why is reducing slippage important when closing in-the-money options?

Reducing slippage is important because the bid-ask spreads for in-the-money options tend to widen, especially in less liquid stocks. This makes it harder to execute trades at fair value, leading to unnecessary losses over time. Market makers hedge high delta options, which increases the spread as a form of protection.

TakeawayTraders should be aware of the widening bid-ask spreads for in-the-money options and plan to execute trades at fair value to minimize slippage.

What does the intrinsic value of an option represent?

The intrinsic value of an option is the difference between the strike price and the current stock price. For in-the-money options, it represents the immediate profit that could be realized if the option were exercised.

TakeawayUnderstanding intrinsic value is essential for managing options positions, especially when closing trades or assessing risk.

What price would I be willing to pay for this?

The speaker suggests that the intrinsic value is 11.75, and the trader should aim to pay 11.75 or 11.77 if possible. If not, they might consider paying up to 11.80, but should avoid paying more than necessary.

TakeawayTraders should aim to pay the intrinsic value plus minimal extrinsic value to avoid unnecessary slippage.

What is the synthetic equivalent of a short put?

The synthetic equivalent of a short put is buying the stock at a low price and selling an out-of-the-money call. This locks in the intrinsic value of the put and minimizes delta risk.

TakeawayTraders can use a synthetic put strategy to replicate the risk and reward profile of a short put by buying the stock and selling an out-of-the-money call.

What is the advice regarding selling options below intrinsic value?

The speaker advises against selling options below intrinsic value, especially when there is time left until expiration. This is to avoid unnecessary risk and potential losses.

TakeawayAvoid selling options below intrinsic value to minimize risk, particularly when there is time remaining until expiration.