I learned about options in a financial mathmatics class a few years ago, and recently I thought I'd buy some for fun/to learn how it's done in real life. I don't like Intel (don't hate me) and it was in the news so I figured I'd try to buy a put so I could sell Intel stock for $50 even though it would hopefully cost less than $50 in the future. When the strike date came, I'd buy some Intel stock (for hopefully less than $50) and close the option.

Except the cost of the option seemed surprisingly high.

I have an etrade account which has basic options privileges. This is what I saw when I looked at buying intel put (except the circle which I obviously just added).

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The high final price surprised me. I thought the price for the put was 0.24, and I thought I was buying one of those. Therefore I expected the total cost to be approximately one quarter dollar.

My questions are:

  • why was this so expensive?
  • what is the 0.25 if it's not the price?
  • E-Trade forced me to make this a limit order since this was in the late evening on Friday. How does that impact the commission/price?
  • (semi related) do I actually have to buy Intel stock when closing the position? Or will etrade just give me the difference between the strike/actual prices minus any fees?

what is the 0.25 if it's not the price

It's the limit price that you apparently set. At that time, you could instantly buy an option contract for 0.27 per share (the ask price), but a limit order tells the broker to "buy when the price is 0.25 or lower". So your order might be filled later or not at all.

why was this so expensive

An option contract is for 100 shares, so you're offering 0.25 per share for a single contract, which would be 25 total (0.25 X 100). Add in the 7.70 transaction fees and the total is 32.70.

E-Trade forced me to make this a limit order since this was in the late evening on Friday. How does that impact the commission/price?

That's because you can't do a "market" order after-hours, and they're protecting you from a overnight run-up so that you end up paying, say 0.90 if the price jumps. With a limit order you will pay 0.25 or lower.

do I actually have to buy Intel stock when closing the position? Or will etrade just give me the difference between the strike/actual prices minus any fees?

In my experience, eTrade physically settles equity options, so yes if the price is below your strike you will have to buy the shares to cover the put option. I can't say for if that will happen automatically, though, as I've never boughts puts with eTrade. You will keep the difference when the shares are sold, but a better choice might be to sell the option right before it expires. The price for the option should be slightly higher than the difference between the strike and the price (if the strike is above the price). That way, you get a little bit of time value to make up for the transaction fee, and don't have to worry about physical settlement.

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  • Good explanation except I'm not sure why you introduced the selling of naked puts. It's a buy order, eh? – Bob Baerker Jun 28 '18 at 13:47
  • @BobBaerker You're right, bad choice of terms. What I meant was I didn't think eTrade would let you buy a put without owning the underlying stock (I've never done it, TBH, only covered calls) – D Stanley Jun 28 '18 at 13:51
  • That would be true for Level 1 option approval (covered calls and long protective puts). Level 2 approval allows the purchase of long options. – Bob Baerker Jun 28 '18 at 14:28

Most of the time it makes more sense to sell the option rather than exercise the it and then have to close the position in the underlying. The reason for this is that the option may have some salvageable time premium and you'll incur fewer commissions.

If an option is one cent or more ITM at expiration, the OCC will automatically exercise your options whether they are long and short (Exercise by Exception). For equity options, you will end up with a position in the underlying (index options are cash settled and they have other issues). If you are long the option, you can designate to your broker that your options not be exercised at expiration. This would make sense if they are ITM by pennies and your commission to close exceeds that..

Where it makes sense to exercise and then buy/sell the stock is if you own an ITM option and the bid trades below parity (less than intrinsic value). By selling at the bid, you'll take a haircut. This makes sense if commission total is less than the haircut. Speaking of which, paying $7.70 for one option contract is highway robbery (nearly 20% of the option's cost).

As an example, IBM is currently $138.75 and the June 29th $150 put has a bid of $10.80. The intrinsic value of the put is $11.25 but the best bid is only $10.80 (most likely the market maker) so that's a 45 cent haircut. You could place an order for a better closing price but you are not likely to get full intrinsic value because there's no incentive for anyone to do so.

If you were to sell your put for $10.80, the market maker would immediately do a discount arbitrage. He'd exercise the put to sell the stock at $150, while simultaneously buying the stock for $138.75 to close the position. The net gain would be 45 cents ( - $10.80 - $138.75 + $150.00).

Assuming you have the funds in your account, you can do this yourself. Where I trade, equity is commission is 50 cents per 100 shares with a minimum ticket of $1. Assignment and exercise are free so my cost to do this on 100 shares would be $1. For 200 or more shares, my cost to do this would be 50 cents per hundred shares in order to save as much as $45 per contract. More realistically, it might be $5 or $10 or $15 but the savings is still significant, particularly when you own a number of contracts.

So no, you don not have to buy Intel stock when closing the position unless the OCC is dealing with an ITM option at expiration and you failed to designate 'Do Not Exercise". But as explained above, you might want to. And no, e*trade will never just give you the difference between the strike/actual prices minus any fees.

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  • I really appreciate the explanation. This may be off topic here, but how can I avoid the highway robbery fees? – sudo rm -rf slash Jun 28 '18 at 15:44
  • Best commission rate depends on the size that you trade and the size of your account. Some places to consider are Interactive Brokers, tastyworks, Lightspeed. Robinhood offers free commissions and that's good for the little guy but I'm a bit skeptical since I have read that they route orders for PFOF (Payment for order flow). If so, that might result in inferior price fills. – Bob Baerker Jun 28 '18 at 16:07

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