When Should You Buy Back the Short Leg on a Credit Spread?
Do you know when you should buy back the short leg of a credit spread? It's important to remember that options trading is about controlling your risk and removing trades that show too much risk without enough profit potential. If you can do this consistently, you'll be well on your way to better returns.
You've made a great credit spread trade, and the market is going the direction you wanted. Congrats to you!
At this point, you've made nearly all the money you could make on the trade, and you're left with a dilemma. In this post, I'm going to walk through the two major scenarios that you might encounter and how you should adjust your trade.
Quick Underlying Move - Premiums Still High
Let's say you sold a SPY $5 wide put credit spread for $1.00, and the underlying stock quickly moved away from your spread, resulting in almost a max profit within a few days of entry. The spread now trades at $0.10 and you've banked a $0.90 profit, but there is still 30+ days to go until expiration.
While this isn't the most common outcome, it does represent a big decision.
Do you stick out the trade for the little premium left or exit the trade completely?
Statistically, you should exit the trade completely and take your money. It's not worth the risk for 30+ days for a small $0.10 profit.
But why wouldn't you buy back the short leg, you ask? Well, at this point you still have a lot of time left until expiration and in all likelihood the option premiums are still very high.
Just because the credit has declined to a nice profit doesn't mean it's a good idea to close the short leg and leave yourself hanging with a long option that has a huge value that could quickly drop.
If the underlying premiums are still high, then you are better off to close the entire spread.
Long Underlying Move - Premiums Are Cheap
Taking the same SPY credit spread from above, let's assume the market moves slowly over the first few weeks, and you finally show the same $0.90 profit, but now there is only 5 days to go before expiration. You are more likely to have this scenario play out over time than the one above.
In this instance, we actually have an opportunity to lock in profits AND possibly leave ourselves room to earn more money.
By this time the individual options premiums are very cheap, so we have wiggle room to make some adjustments.
You could then buy back the short leg of the credit spread, leaving the long option left as a lottery ticket. Ideally, this remaining option would only be worth a couple pennies at the most. This way if your lottery bet doesn't pay off you don't go negative on the whole trade in the end.
You don't expect to make money with the long option, but you also protect the profits you have and remove the risk IF the market moves against you in the last couple days. You won't lose the credit already banked and you might make a couple extra dollars if the move is big enough.
Individual Options Premiums Determine Buy Back Timeframe
As you've seen, deciding when to buy back the short leg on a credit spread has nothing to do with the underlying market but rather where the premiums are on the options you are trading.
If they are super cheap, go ahead and buy it back. If not, it might be worth waiting more or closing the trade at a profit.