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I'm long some puts on a stock that has dropped a great deal. I've made $400,000 on an investment of $100,000.

The question is, how do I exit? I can't really sell the puts because there isn't enough open interest in them now that they are so far out of the money.

I have about $150K of funds outside of this position that I could use, but I'm confused by the rules of exercising a put. Do I have to start shorting the stock?

Kind of embarrassing that I had this big win without really knowing how to unwind the position...

  • Place a sell limit order in the market - open interest is mostly irrelevant and does not mean that you can't sell. At the right price you will surely find a counterparty. – assylias Dec 14 '13 at 16:55
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The question is, how do I exit? I can't really sell the puts because there isn't enough open interest in them now that they are so far out of the money.

I have about $150K of funds outside of this position that I could use, but I'm confused by the rules of exercising a put. Do I have to start shorting the stock?

You certainly don't want to give your broker any instructions to short the stock!

Shorting the stock at this point would actually be increasing your bet that the stock is going to go down more. Worse, a short position in the stock also puts you in a situation of unlimited risk on the stock's upside – a risk you avoided in the first place by using puts. The puts limited your potential loss to only your cost for the options.

There is a scenario where a short position could come into play indirectly, if you aren't careful. If your broker were to permit you to exercise your puts without you having first bought enough underlying shares, then yes, you would end up with a short position in the stock. I say "permit you" because most brokers don't allow clients to take on short positions unless they've applied and been approved for short positions in their account.

In any case, since you are interested in closing out your position and taking your profit, exercising only and thus ending up with a resulting open short position in the underlying is not the right approach. It's not really a correct intermediate step, either.

Rather, you have two typical ways out:

  1. Sell the puts. @quantycuenta has pointed out in his answer that you should be able to sell for no less than the intrinsic value, although you may be leaving a small amount of time value on the table if you aren't careful. My suggestion is to consider using limit orders and test various prices approaching the intrinsic value of the put. Don't use market orders where you'll take any price offered, or you might be sorry.

    If you have multiple put contracts, you don't need to sell them all at once. With the kind of profit you're talking about, don't sweat paying a few extra transactions worth of commission.

  2. Exercise the puts. Remember that at the other end of your long put position is one (or more) trader who wrote (created) the put contract in the first place. This trader is obligated to buy your stock from you at the contract price should you choose to exercise your option.

    But, in order for you to fulfill your end of the contract when you choose to exercise, you're obligated to deliver the underlying shares in exchange for receiving the option strike price. So, you would first need to buy underlying shares sufficient to exercise at least one of the contracts. Again, you don't need to do this all at once. @PeterGum's answer has described an approach.

    (Note that you'll lose any remaining time value in the option if you choose to exercise.)

Finally, I'll suggest that you ought to discuss the timing and apportioning of closing out your position with a qualified tax professional. There are tax implications and, being near the end of the year, there may be an opportunity* to shift some/all of the income into the following tax year to minimize and defer tax due.

* Be careful if your options are near expiry!  Options typically expire on the 3rd Friday of the month.

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While open interest usually correlates to volume, the mark of liquidity is the bid ask spread.

Even when trading options with spreads as large as an ask 2x the bid, a more realistic price that traders are willing to accept lies somewhere in the middle.

Any option can easily be exited at intrinsic value: underlying price - exercise price for calls, exercise price - underlying price for puts. For illiquid options, this will be the best price obtained. For longer term options, something closer to the theoretical price is still possible.

If an underlying is extremely liquid, yet the options aren't quite then options traders will be much more ready to trade at the theoretical price.

For exiting illiquid options, small, < 4 contracts, and infrequent, > 30 minute intervals, orders are more likely to be filled closer to the theoretical price; however, if one's sells are the only trades, traders on the other side will take note and accept ever lowering implied volatilities.

With knowledge of what traders will accept, it is always more optimal to trade out of options rather than exercise because of the added costs and uncertainty involved with exercising and liquidating.

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You are long the puts. By exercising them you force the underlying stock to be bought from you at your strike price. Let's say your strike it $100 and the stock is currently $25. Buy 100 shares and exercise 1 (bought/long) put. That gives you $7500 of new money, so do the previous sentence over again in as many 'units' as you can.

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