Probability of Deep ITM far out options being exercised?

Discussion in 'Options' started by matgallis, Feb 25, 2009.

  1. Hey all,

    I'm seeking some advise for some expectations for a few trades i wish to implement. However, these option trades are 2 years out, and very deep ITM. I know American style options may be exercised at ANY time and i'm subject to losses/gains accordingly.

    I wish to hold these options until/near expiration, please do not ask why. So i'm seeking information on, why might the option be exercised early, odds of early exercise even with the stock being so far out and so deep ITM, and any noteable suggestions about early exercise. Like I said, I need/wish to hold close to expiration.

    Thanks all
  2. It would only be to save money on the entry, nothing more, but usually it's not beneficial. I suggest finding a broker that offers European options if that's actually your plan. They'll be cheaper.
  3. Save money = slippage? So they arb the slippage by buying my ITM call, exercising it, then selling it for the small gain?

    I was going to start looking into foriegn markets for European options, but that subjects me to fx risk
  4. Good question. Like so many good questions, the answer is: it depends.
    The most critical factor is how much value will be lost if the option is exercised. For example, if the stock price (S) is 95.00 and the exercise price is 40.00 (X) , the option holder can exercise and receive 55.00 from the difference between the stock price and the exercise price (S-X). If the option value is 56.00 then, the holder will lose 1.00 if he exercises. 99% of the time, he would not choose to exercise in that case because it makes no financial sense. If the option value was 55.15, and the bid-ask spread is fairly wide, then exercise is much more likely because it makes more sense financially to cash in your chips, so to speak.
    In your case the factor that makes a difference is the amount of outstanding options (called the open interest). If the amount of options outstanding is quite high- say several hundred or more, then you are less likely to have a problem. The official policy is that option sellers are randomly assigned when exercise occurs. In reality, I'm not so sure that this is strictly observed. If you are a big client, you may be able to influence this a bit. That said, if you have 10 calls, you may easily dodge the bullet if there are a thousand calls outstanding.
    Typically, I use index options, which are European style, and this is never an issue at all.
  5. spindr0


    If the option trades below parity (at a discount), there's a good chance that you'll be assigned early. As long as there's time premium remaining, it's unlikely - it happens but very infrequently. The discount can occur with very deep ITM options and sometimes with pending dividends.
  6. 1) As you know you have no control. The decision to exercise rests with the option owner. Thus, you should be able to hold all the way to expiration, but there is nothing you can do about it.

    Despite one responders suggestion to the contrary, there is NOTHING you can do to change your chances of being assigned.

    2) If the option is far out of the money (you did ask about this) there is absolutely zero chance of being assigned. The only exception: If expiration arrives and the option is OTM by a penny, it's possible, but unlikely you will be assigned an exercise notice.

    3) The chances of being assigned an exercise notice on a CALL option that is deep ITM is far less than the possibility of being assigned on a PUT option that is deep ITM

    4) With lots of time remaining, there is little chance you will be assigned. Period.

    5) As time to expiration decreases, the chances of being assigned increase.

    6) Odds? Low.

    Why would anyone exercise a call option: To collect a big dividend. But, when the dividend is collected, the option exerciser owns the stock, and if he carries that position to expiration, must pay interest . that's known as the 'cost to carry.' Most of the time that cost to carry is so high that it would be stupid to exercise the call (and then be subject to downside risk).

    Why would anyone exercise a put option: If the put owner also owns stock, then the interest cost of carrying the stock plus the long option may become significant when the put is DITM. If it's costly to carry, and if the put is deep enough ITM so that the put owner has no realistic expectation that the stock will ever move past the strike (before expiration), it's not a bad idea to exercise and sacrifice the cost of paying that interest.

    How can you tell if this is likely: If the call option with the same strike and expiration date as the put can be purchased for less than the cost of carry, the intelligent investor buys the call and exercises the put.

    Tips: I have none. If you anticipate an exercise may be imminent because of a dividend or the cost of carry, you can roll the option you sold to a longer term option.

  7. spindr0


    Hey Mark. I'd put a decimal point with a bunch of zeros next to that "absolutely zero chance of being assigned". It's rare but once in a blue moon stupid money comes into play. 3-4 years ago I had some short MSO calls with 2 points of time premium assigned a month before expiration. Happiest day of my option life (g) as I covered the stock and sold them ASAP. So maybe it's point zero zero zero one? :)

  8. I'm still going with my short answer, which is to save money on entry.
  9. thanks for the replies dangty and others. I will weigh the risk/reward and carry thru my strategy
  10. You can 'go' with your short answer, but that answer has nothing to do with the question (which was related to risk of assignment).

    #10     Feb 26, 2009