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Suppose:

  1. I bought an American put on a stock in a retail brokerage IRA, where I can't sell short or write uncovered options.
  2. The put is ITM and has served its purpose for hedging.
  3. The put is thinly traded and nobody is making reasonable bids.
  4. The put still has significant time value, so I don't want to just exercise it and give up that value

How can I "synthetically" sell the put (subject to the constraints in #1)?

One thing I could do is to "delta" buy and delta-scale a long position in the underlying. If I do this during the time to expiration then in expectation I will realize the time value of the put.

The problem with this strategy is that it leaves me exposed to volatility: If the realized volatility is lower than the current implied volatility then in expectation the realized value of the put will be lower than the fair value at the moment I wanted to sell it.

Is there a practical way to hedge the volatility exposure, subject to the constraints in #1?

Or, is there a better way to synthetically sell the put?

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  • $\begingroup$ Maybe you could try taking the synthetic trade in another account that does let you enter short positions. Then your net pnl across the two accounts would achieve what you want. However, you will likely have to own stock/cash to sell any option you do not own no matter the route you go. $\endgroup$ – roz Mar 3 '20 at 18:01
  • $\begingroup$ @roz I posed this here more as a question of theory than of practice. I have encountered the problem in real life, but in practice the answer tends to be more "Oh well, illiquidity sucks." $\endgroup$ – feetwet Mar 3 '20 at 18:33

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