Minyan Mailbag: Exercising Options
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.
I need your help as an option guy. I recently got exercised for some XAU calls I had just written. I did not think there was any point in early exercise of a cash settled option; also how is it possible to avoid this, I mean, checking the open interest before trading, I do not know. I wonder if you can help me because nobody seems to know anything about the issue.
I answered a mailbag the other day where a thoughtful Minyan explained that before entering any trade he tries to understand the motivation behind the "other side". This is great advice. A different way to put it is, "what are my risks, what is the worst that can happen?"
Any contract or agreement in life I look at as an option: what will I receive and what will I pay? What can the other party do to me if they want to, no matter the probabilities? Those probabilities can be assigned once I know the possible outcomes.
In this case because the option is American it can be exercised at any time. So first we know what can be done to us if we are short that option. In order to assign a probability, we need more information.
We also know that it is cash settled. That means if it is exercised we have no position coming in afterwards and just receive cash based on the value of the option. In other words we are marked to the closing price with no position left.
From the point of view of the holder of the option, this means that he
also has no position. And there lies the answer. The holder of the option wanted to liquidate his position at the close and this was a way to do it with no market impact.
The holder of the option was long calls and wanted to sell his long exposure to gold at the closing price. These must have been in the money calls because he would lose any time premium left in the calls by exercising. So he weighed the loss of time premium (if there was any) against the market impact of waiting to the next day.
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