You're Giving Free Money to Market Makers Every Time You Close an ITM Option. Here's How to Stop.

Key Concepts

• Slippage: The difference between the expected price of a trade and the price at which the trade is actually executed.
• Intrinsic Value: The portion of an option's price that is "in-the-money" (Stock Price - Strike Price for puts; Strike Price - Stock Price for calls).
• Extrinsic Value: The portion of an option's price attributed to time remaining and volatility; often negligible in zero-days-to-expiration (0 DTE) options.
• Synthetic Positions: Using a combination of stock and an opposite option to replicate the risk profile of an existing position to avoid unfavorable bid-ask spreads.
• Assignment/Exercise Risk: The process where in-the-money (ITM) options are automatically converted into stock positions at expiration.

1. The Problem of Slippage in ITM Options

Trading ITM options often involves wider bid-ask spreads compared to at-the-money or out-of-the-money (OTM) options. Market makers widen these spreads as a form of protection because ITM options have high delta (they move tick-for-tick with the stock). When a trader "lifts the offer" or "hits the bid" without regard for intrinsic value, they effectively pay a premium to the market maker, which erodes profitability over time.

2. Valuation Framework

To minimize slippage, traders must understand the components of an option's price:

• Formula: Option Price = Intrinsic Value + Extrinsic Value.
• The "Mirror" Principle: The extrinsic value of an ITM put is theoretically equivalent to the extrinsic value of an OTM call at the same strike price.
• Benchmark: When closing an ITM position, the intrinsic value should be the primary benchmark. Avoid paying more than (Intrinsic + Extrinsic of the OTM counterpart) when buying back, and avoid selling for less than the intrinsic value.

3. Strategies for Closing ITM Positions

A. Direct Execution (The "Fight for Pennies" Approach)

If you must close the position directly:

• For Short Puts: Do not pay significantly above the intrinsic value. If the intrinsic value is $11.75, placing a bid at $11.75 or $11.77 is preferable to lifting an offer at $12.65, which would result in roughly $0.90 of unnecessary slippage.
• For Long Puts: Do not sell below the intrinsic value. Selling below this level allows the market maker to immediately hedge by buying the stock and exercising the option, capturing the difference as risk-free profit.

B. Synthetic Alternatives (Risk Management)

If the bid-ask spread is too wide to get a fair fill, use synthetic positions to neutralize risk without closing the option:

• Synthetic Long Put (to close a Short Put): Short the stock and buy the corresponding OTM call. This locks in the intrinsic value. At expiration, the call expires worthless, and the assignment of the short put (resulting in long stock) offsets the short stock position.
• Capital Requirements: These strategies are capital-intensive and require sufficient account size to hold the underlying stock positions until expiration.

4. Important Considerations

• Expiration Risk: If an ITM option is not closed by expiration, it will be automatically exercised or assigned, resulting in a stock position in the account on the following Monday. This may trigger margin calls or unwanted exposure.
• Market Maker Behavior: Market makers are incentivized to capture the spread. If a trader sells an ITM option below intrinsic value, the market maker buys the stock, exercises the option, and pockets the difference.
• Data Accuracy: Be wary of platform-calculated "extrinsic value" for ITM options. Because bid-ask spreads are wide, the "mid-price" used by platforms can be misleading. Always calculate intrinsic value manually based on the current stock price and strike price.

5. Notable Quotes

• "Reducing slippage when trading in and out of option positions is one of the ways you can tell a real solid trader from a so-so trader."
• "If you sell [an ITM put] for 11.60... the market maker immediately buys the stock... exercises the put... and captures the difference. That’s why he’s driving the Ferraris and you’re not."

Synthesis

The core takeaway is that ITM options require a disciplined approach to execution to avoid "giving away" money to market makers. Traders should treat the intrinsic value as a hard floor or ceiling for their orders. When liquidity is poor and spreads are wide, utilizing synthetic positions is a superior alternative to accepting poor fills, provided the trader has the capital to manage the resulting stock positions.