How to Close In the Money (ITM) Options
Front-month out of the money (OTM) options and at the money (ATM) options boast the best liquidity out of all options. As options become “in the money (ITM)”, liquidity declines dramatically, and the bid-ask spread gets very wide.
Today’s article will use a set of specific option quotes to analyze in detail how to close ITM options.
Take my own BTC-26MAR21 call option for example. Currently, the price of BTC spot index is $46,892, and the price of 26MAR21 synthetic futures is $48,478. The value of BTC options on Deribit is calculated based on synthetic futures prices.
Prompt: What are Deribit’s synthetic futures prices?
Our riskmanagement system now calculatessynthetic futures prices for options expirydate without corresponding futures. Thissynthetic futures price is obtained via linearinterpolation between existing futures mark prices, and will be used for options mark pricing and risk management. Symbol for this imaginary future is the same a a normal future but preceded by “syn”, for example “SYN.BTC-5JUL19”. The objective is more correct mark prices for options that have no corresponding future. Currently we do only interpolation between futures or between index and future and no extrapolation.
For call options:
§ Those with strike prices between 0 and $48,478 are ITM options;
§ Those with strike prices at around $48,478 are ATM options;
§ Those with strike prices above $48,478 are OTM options.
Prompt: Intuitive understanding of whether an option is OTM or ITM
OTM options are less promising as they have a poor chance of profitability, whereas ITM options are more promising as they have a good chance of profitability.
At this expiry date, I have 0.1 call option with a strike price of $28000 and have already earned a profit of over 100% based on the BTC standard (the cost of each option is 0.2050 BTC). Now I wish to “take the profit”. Now, let’s look at the market shown below.
The options I hold are calls. I need to sell them to close the positions. The best bid offered by the counter party is 0.4215 BTC, which is 0.0123 BTC lower than the mark price of 0.4338 BTC, and the price difference is significant.
Prompt: Deribit’s mark price
Mark Price is an estimate of the current market price of an option. It is used to calculate such parameters as the profit-and-loss of the positions, account equity and margin balance.
The difference between the best bid and the mark price here will cause me to suffer a profit loss of 0.0123 BTC per option compared to the estimated profit of the mark price when I sell the options. Compared to the cost of 0.2050 BTC I paid, my actual profit is 6% less than the promised profit, which is a significant difference.
Let’s take a look at OTM options. Assume that the strike price is $64000, the best bid 0.0550 BTC, and the mark price 0.0552 BTC. The difference between the best bid and the mark price is only 0.0002 BTC. By this comparison, you can have a clear idea how poor the liquidity of ITM options is.
Therefore, if I wish to reduce slippage when I close positions, I can only choose maker orders instead of taker orders. Click the quote of the option with the corresponding strike price to enter the option order page as shown in Screenshot 3 below.
First, take look at order filling by the absolute value of the premium, which is the BTC order mode shown in Screenshot 3 above.
The green number 0.1 under quantity is the number of call options I hold now. If what I hold are put options at this strike price, the number here will be shown in red.
The mark price of ITM option at this strike price is 0.4359 BTC. If you offer a maker order according to the current best ask of 0.4540 BTC, your buyer will need to withstand very high slippage. In this case,
· If your buyer is a trend speculator, why don’t he/she go for an OTM option with lower slippage, progressive Gamma increase, and less premium?
· If your buyer is a market maker or volatility surface arbitrage player, why would he want to take your order at this best ask with such high slippage? The slippage is high; it takes up a lot of margin; and the liquidity is poor.
In summary, it is unrealistic to wish the market to fill your maker orders of ITM options according to the best ask. At least you should offer quotes close to the mark price, such as 0.4360 BTC or 0.4355 BTC, or even lower. Only in this way can you get the orders filled within a reasonable period of waiting.
However, if I offer a maker order at a price of 0.4355 BTC, some problems will follow:
If the market price has skyrocketed, there will be much less unfilled orders, and the option mark price may increase to 0.5000 BTC. In this case, my order is still priced at 0.4355 BTC, which means that I will suffer a loss due to market fluctuations. In absolute terms, there is no loss; but when we look at this from the perspective of implied volatility (IV), this order filling is a big loss — because I could have sold this option at a higher premium in the booming market, probably at a price of 0.4950 BTC instead of 0.4355 BTC.
If the market price has slumped, and the option mark price drops to 0.4000 BTC, my previous sell order priced at 0.4355 BTC will be moved to the end of the sell list. If I do not adjust the quote manually, this order will never be filled.
Thus, you can see the problems of order filling by the absolute value of the premium.
The solution to closing an ITM position is to use an IV order. If the basis of the order is IV, the exchange will adjust the absolute value of the maker order’s premium every 4 seconds according to the latest underlying price (i.e. the price of BTC futures/synthetic futures for this term) at the IV you set. This avoids the pain point of maker orders either suffering losses or not getting filled in a volatile market.
So, how do you select an IV for an IV order? For ITM options, the easiest reference is the IV at the mark price. It can be seen from the market performance that the IV corresponding to the mark price of the $28000 call option is 126.8%. We just need to enter 126.8 in the IV order as shown below.
If you sell the ITM option at the mark price and the order is still unfilled, you will have to adjust the volatility down further. So, what is the best position to adjust the volatility to?
If we just look at the quote of the call option, the IV corresponding to the best bid is only 85.8%, which is 40% lower than the IV at the mark price. This is too much of a difference and too much of a loss.
So, what should you do in this case? Here I am going to introduce a concept called Put Call Parity (PCP). See Screenshot 5 below.
The synthetic futures price is $48266. The ITM level of a call option with a strike price of $28000 is $48266 — $28000 = $20266, which translates to $20266 / $48266 = 0.4198 BTC.
The premium mark price of 0.4333 BTC minus the ITM level of 0.4198 BTC arrives at the time value of the option, which is 0.0135 BTC.
And the put option with the same strike price is out of the money. It does not have ITM level, but only has time value. What is the amount? 0.0139 BTC. The two amounts are basically the same factoring in difference in some calculation errors.
The mark IV of call options and put options with the same strike price is the same. In other words, the call option and put option with the same strike price have the same time value and IV after subtracting the ITM value. This is Put Call Parity (PCP).
For a Put with a strike price of $28,000, the IV of the best bid is 124.7%. When we sell ITM Calls, we can simply use the IV of the best bid of Put as the bottom line. In other words, the IV of the sell order should not be lower than 124.7%.
As shown in Screenshot 6 below, if we set the price of the maker order by the IV of 124.7%, the difference between the amount of its BTC premium and the mark price will be very small.
Based on my experience, a maker order can be filled in a few hours if you quote at a price based on the IV of the counter party’s OTM option with the same strike price, and you can also reduce the slippage significantly.
I hope this article is helpful to you.
The legends/screenshots shown in this article are generated from the order page on www.greeks.live/web/. You are welcome to use the page more. Your encouragement is our motivation. We will follow up with more practical guide articles on a regular basis.
Jeff Liang
February 15, 2021
