As Expiration Day Approaches
Jim Gaham

In-the-money calls and puts often trade for less than their intrinsic value (the difference between the stock price and strike price) on, or near, expiration day. This is especially true for deep-in-the-money options. It also seems like once you get close to expiration day and there is very little time premium left in deep in-the-money options, the problem is even more prevalent.
Let me give an example based on real-life situation I saw recently. The underlying stock was trading for $70.70. The June 65 calls only had one day left until expiration, so you would expect them to be trading at, or very near, the intrinsic value of $5.70. However, the option was quoted at only $5.20 on the bid.
Many investors would accept this as normal and close their positions below the intrinsic value. After all, while options pricing theory may say that an option should not trade for less than its intrinsic value (less any commissions), things are rarely as neat in real life, right? Not true. There are ways that you can get the full value for your option position.
Closing Long Call Positions
So let’s say you owned 20 of the June 65 calls in the example above and wanted to close your position. Selling at the bid price you would receive $5.20 x 20 x 100 = $10,400.
But there is a better way, and it is based on options pricing theory. Option theory is partially based on the idea of arbitrage, and it says that an option should not trade for less than intrinsic value. If it does, arbitrageurs would sell the stock and buy the call for a guaranteed profit. The buying and selling pressure would continue until the option price equals its intrinsic value.
So how can you close an in-the-money option that is trading below parity? The same way the arbitrageurs would. Instead of selling your call at the bid, place an order to sell the stock. Once that sell order has been executed, immediately exercise the call option.
With the above example of owning 20 of the June 65 call options, you would place an order to sell 2,000 shares of the stock at the current price of $70.70. Once the sell order is executed you then submit your exercise instructions to your broker. That will result in you buying 2,000 shares at the strike price of $65. Doing this results in you receiving $70.70 on the sale of the stock, and then buying it back for only $65 with the exercise of the call options. The net proceeds would be $5.70 x 20 x 100 = $11,400. That is $1,000 more than you would have received if you just accepted the Bid price for your options!
It is possible that the commission charge from your broker may be slightly more to do it this way, but not necessarily. Looking at the standard commission rate of one of the higher-priced discount brokers I saw that the charge for doing the offsetting option transaction would cost $30 vs. $29.90 for the stock sale and option exercise.
Some people (including some brokers) may suggest you "short" the stock instead of putting in a regular sell order. However, shorting the stock subjects you to unnecessary risk. You can short a stock only on an “uptick”, and there is never a guarantee that will happen. So you may never even get the stock sold. Also, if you short the stock you are subject to the 50% Regulation T charge, and may not earn interest on that amount over the 3 business day settlement period.
You may hear objections about selling shares that are not in your account. But the regulations certainly allow it (although it is possible you have an individual broker that does not). In these days of Internet trading, with most shares held by brokers in street name, it may be hard to remember back to when most investors kept stock certificates in a safe deposit box and often called in sell orders without the shares at the brokerage firm.  But it is perfectly acceptable to put in a sell order without the shares being physically at your brokerage firm as long as they are delivered within the settlement period.
Even if your firm does require the shares to be in your account for you to sell them, just let your broker know that you will be immediately submitting exercise instructions to purchase the shares. There is no reason they shouldn't allow it, since the Options Clearing Corporation (OCC) guarantees the delivery of the shares at settlement.
So once you sell the stock, immediately submit exercise instructions. It is important to submit your exercise instructions on the same day or the sale of stock and purchase from the option exercise will not settle on the same day. While it’s not a big problem if that happens, I’m sure your broker would be unhappy if you made a habit of doing it.
Closing Long Put Positions
What if instead you are long put options? On that same stock, the in-the-money June 80 put options were being quoted at a bid of $8.80. Selling 20 of those puts to close out a position you would receive $8.80 x 20 x 100 = $17,600.
But with the stock at $70.70 the options had an intrinsic value of $80 - $70.70 = $9.30, a difference of 50 cents! The way to capture this difference in the case of put options if they are trading below intrinsic value is to buy the stock and then exercise your puts.  
So in this example you would pay $70.70 to buy the stock, and then receive the strike price of $80 from the exercise of the put. That means you receive the full intrinsic value of $9.30 or net proceeds of $18,600 for the 20 contracts – an additional $1,000! Again, any extra commissions you may have to pay will be well worth it.
Should You Try to Play Market Maker?
Why do options sometimes trade below their intrinsic value? It usually is because the market makers are having difficulty laying off their risk. But it basically comes down to the law of supply and demand. There are simply more sellers than buyers. On (or near) expiration day, everybody wants to sell their calls, but nobody wants to buy them. The market maker is always willing to buy, of course, but he will naturally try to get as big a premium as he can get for providing that service.
So why isn’t anybody buying the calls and selling the stock to restore equilibrium? The answer is that they are. The market makers are buying at the bid price and then selling the stock. However, there can be times where there is not enough volume or interest to bring prices into equilibrium. If the market maker buys the call option from you and the stock continues to fall, they end up with a loss by the time they short the stock (even though market makers are immune to the "uptick" rule). So they charge a premium to cover their risk while awaiting executions.
What about arbitrageurs or retail investors? Why don’t they join in and buy the call and sell the stock? They can, but not only will they have commission costs, they have to purchase the call at the ask price and sell the stock at the bid price. With the wider spreads common with deep in-the-money options that leaves little or no room for error.
When you notice large differences between the quoted price and intrinsic value, you may be tempted to think about trying to compete with the market makers. After all, that looks like a lot of money just sitting there to be picked up for little or no risk. But I would not recommend it.
Let’s see what could have happened in the above example with the June 65 call being quoted at $5.20 bid and $5.90 asked. What if you simply put in an order for your 20 contracts with a slightly higher bid price, say $5.50? Now you are the highest bidder. The quote will move to $5.50 on the bid and $5.90 on the asked.
But there is a catch: if you bid at $5.60 the market makers will bid $5.60. How do I know that will happen? Because you would be giving them a call option for 10 cents!   Market makers love to buy deep in-the-money call below their fair value. Then if the stock were to fall in price the market maker would just it to you at $5.50. For almost no risk, their worst possible outcome would be losing 10 cents. In other words, they would use your buy order as their guaranteed stop order. If they buy it for $5.60 and it doesn't work out, they know they have a buyer at $5.50 – you!
There used to be an order called "exercise and cover" that you could use in either of these cases. It meant the broker would sell the stock, covering the sale by exercising the call (or to buy the stock and cover by exercising the put). With the increased liquidity in the options markets this order is no longer used, but that doesn’t mean you can’t do it yourself in two separate transactions (and at considerably lower cost in commissions now than in the past).

To get the best return you possibly can, it is important to understand how options work and the markets they trade in. Just because the market is offering you a price below fair value doesn't mean you have to accept it. And it also helps considerably if you have a broker that fully understands options and can execute your instructions properly.