Exercise & Assignment of Index Options - Part Two
Options allow the creation of synthetic positions, a feature lacking in underlying asset markets. The creation of a synthetic position can be executed in numerous ways, but invariably the cost of funding the identical position will dictate the manner in which the investment ought to be driven.
The underlying asset itself can be purchased in the outright market or it can be synthesized through the purchase of a call and the sale of a put of the same strike price. If this can be accomplished at a net receipt of extrinsic value, the synthetic alternative will prevail as it achieves a stock price of lower than available in the market. Certainly a profit can be realized immediately, but for the intents and purposes of investment, the return will be higher due to the lower cost of the investment.
Certainly it is arguable that all equity ownership, just as option purchase, is limited in its risk due to the purchase price representing all that can be lost. In the case of equities, the sum is considerably larger than that of an option premium.
If a call option is exercised, and the underlying asset is then held, unlimited risk is exchanged for limited risk. Still, the call option can be resurrected by purchasing the equivalent number of put options of the same strike. In this event, the extrinsic value of the call is forever lost, and the cost of funding the underlying asset ownership will also be imposed. Still, dividends on stock may accrue to offset against expenses.
If however, the put of the same strike is also able to be purchased at a level that results in an overall saving, the time value will again be retained, but an additional funding cost will be incurred for the value of the put, and risk will again be limited to the value of an option premium.
Essentially, it is the size of a dividend that may support the entry into this synthetic strategy. If the dividend offsets the cost of funding to such an extent that the proposition is viable, the synthetic call will be preferred to the literal call.
In the case of a synthetic put, it too will be executed in careful consideration of dividends, but will involve interest income from sale proceeds being balanced against the paying of a dividend to the holder of the underlying stock, and further outlay for call options of the same strike.
When a synthetic call is held however, the investor has the convenience of exercising the put option and delivering the stock directly. This will cause a realization of profits or losses and effectively close out the position. If however, the call option is sold, the extrinsic value of the call is received as additional income, and yet the strategy results in a conversion; a synthetic underlying asset that offsets a physical underlying asset. If the extrinsic value received is able to generate a profit that is greater than that derived from exercising the put and receiving income on the proceeds, the conversion will be the astute strategy to follow.
In all option trades it is advisable to consider funding costs as that including the funding of margin requirements in addition to that merely for capital outlay for assets. If this method is adopted, there will be no unexpected erosion of returns due to the cost of funding margins when an option is exercised.
The underlying asset itself can be purchased in the outright market or it can be synthesized through the purchase of a call and the sale of a put of the same strike price. If this can be accomplished at a net receipt of extrinsic value, the synthetic alternative will prevail as it achieves a stock price of lower than available in the market. Certainly a profit can be realized immediately, but for the intents and purposes of investment, the return will be higher due to the lower cost of the investment.
Certainly it is arguable that all equity ownership, just as option purchase, is limited in its risk due to the purchase price representing all that can be lost. In the case of equities, the sum is considerably larger than that of an option premium.
If a call option is exercised, and the underlying asset is then held, unlimited risk is exchanged for limited risk. Still, the call option can be resurrected by purchasing the equivalent number of put options of the same strike. In this event, the extrinsic value of the call is forever lost, and the cost of funding the underlying asset ownership will also be imposed. Still, dividends on stock may accrue to offset against expenses.
If however, the put of the same strike is also able to be purchased at a level that results in an overall saving, the time value will again be retained, but an additional funding cost will be incurred for the value of the put, and risk will again be limited to the value of an option premium.
Essentially, it is the size of a dividend that may support the entry into this synthetic strategy. If the dividend offsets the cost of funding to such an extent that the proposition is viable, the synthetic call will be preferred to the literal call.
In the case of a synthetic put, it too will be executed in careful consideration of dividends, but will involve interest income from sale proceeds being balanced against the paying of a dividend to the holder of the underlying stock, and further outlay for call options of the same strike.
When a synthetic call is held however, the investor has the convenience of exercising the put option and delivering the stock directly. This will cause a realization of profits or losses and effectively close out the position. If however, the call option is sold, the extrinsic value of the call is received as additional income, and yet the strategy results in a conversion; a synthetic underlying asset that offsets a physical underlying asset. If the extrinsic value received is able to generate a profit that is greater than that derived from exercising the put and receiving income on the proceeds, the conversion will be the astute strategy to follow.
In all option trades it is advisable to consider funding costs as that including the funding of margin requirements in addition to that merely for capital outlay for assets. If this method is adopted, there will be no unexpected erosion of returns due to the cost of funding margins when an option is exercised.
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