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Is there a case, where due to illiquidity, exercising out-of-the-money options could be better than directly buying the stock?

When a stock is too illiquid, there are some costs because of this illiquidity. Ie, directly buying the stock through a market order could move the price too much.

So, if you exercise options that are out-of-the-money, you won't move the market and won't pay the cost due to the illiquidity.

For example:

There is a stock XYZ whose market price is \$10.00.

You have 100 call options with a strike of \$10.08. (Assume they are very close to maturity, so that the premium is worth nothing or nearly nothing).

If stock XYZ is too illiquid, buying 10,000 shares could move the market and you can end up buying it at an average price of \$10.15. In that case, exercising the option would have given you a better price, even thought they were out-of-the-money.

Is such a case possible? If so, exercising options that are out-of-the-money can be worth it, right?

Or am I missing something and my example is not possible (because there would be an arbitrage opportunity for example)?

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I would say the situation you describe arises more from limited supply, rather than from (the somewhat different concept) illiquidity. – bquast May 16 '12 at 8:54
I think that the lack of supply or demand on a stock, could be qualified as illiquidity. Because it will be very hard to sell or buy without moving the market, thus incurring losses. – Mesop May 21 '12 at 12:13
yes, I agree. What I was trying to suggest was that illiquidity is a bit broader than limited supply (e.g. market regulations). So it would be clearer to use limited supply, because that seems to be the only factor at work here. – bquast May 21 '12 at 12:31
Note that the lack of liquidity in the cash market usually follows straight thru to the derivatives market (although deriviates are more liquid on balance). So compare the effective spread of the option price vs. the cash market spread. – Ram Ahluwalia Jun 1 '12 at 13:01
up vote 2 down vote accepted

No, exercising an out-of-the money option is never worth it. In your scenario, you should start buying at \$10. Keep buying until you push the ask up to \$10.09, then exercise however many options it takes you to get to 10,000 shares. This will get you your 10,000 shares at a lower cost than simply buying them all for $10.08 through exercising your options.

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That's what they meant. Assume the following order book: 1 for \$10.00, 20000 for \$10.50. So essentially you're algo applies and you're both right. Exercising is cheaper. – hroptatyr Jun 1 '12 at 11:53
@hroptatyr: I don't see the answer you are referring to, but ok, so long as it is understood you will not exercise an OTM option. In my answer, the options are ITM when you exercise them. – Beaker Jun 1 '12 at 21:37

That's an interesting question, and I believe your example does indeed show that the answer is "yes". However, just because you paid a lower average price doesn't mean that there isn't market impact, especially if the writer of the option was naked (didn't have the stock already and had to buy it himself on the open market). It's just that the holder of the option is the one not paying the transaction costs for that impact.

I'm also inclined to believe that if enough smart arbitrageurs notice the liquidity effect, they could bid-up the option's premium even if the contract is near expiration. That arbitrage would work in your favor, of course.

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Whether or not to exercise an option when the underlying is near the money can be a very complicated problem that depends on much more than simply whether or not the underlying is just over or under the strike price. Options traders refer to this as pinning, which tends to happen much more often than you might expect if stock price movements were truly random. If you are interested in pinning, and particularly in the "pin risk" that a short options trader faces, I suggest you read Chapter 12 of Euan Sinclair's Option Trading.

For example, suppose one owns call options and actually wishes to be fully hedged against directional movements. On the days prior to expiration, if the underlying is trading near the money, the holder would be short about half the shares represented by the option. Then if in the minutes or hours leading up to the closing the underlying is trading below the strike, the holder may choose to cover the short and personally commit to not exercise the option. If later on the underlying rises above the strike, but the commissions and market impact from reversing the trade (shorting the shares again) would likely push the underlying back below the strike, the holder may choose to "sub-optimally" not exercise an option that is in the money.

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It definelys happens and it strongly depends on the underlying market.
In Europe the closing prices are created in an auction and in this process you might end up with partial fills (as you do not see bid/ask quantities, just crossed/uncrossed).

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Another consideration here is whether the option is settled in cash or the security. For example S&P100 options listed on the CBOE are cash-settled which means that you will receive the cash difference between the strike and the price, and not the underlying security. In this case, there is clearly no benefit to exercising when the underlying is out-of-the-money.

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