OAP 111: Should I Buy Back My Penny Options Or Let Them Expire Worthless?

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You made an options trade and the position has gone well, leaving you with a nice fat profit as expiration approaches. Now the question becomes, what do you do with these cheap out of the money option contracts you sold? Do you buy back your penny options or let them expire worthless? Are there risks to do one over the other and when should you lean one way or not? On today's show I'll talk through what our research shows about exiting trades early, when to just leave them on to expire worthless, and who it all impacts your bottom line profit and loss.

Key Points from Today's Show:

  • At Option Alpha, we buy back many of our option contracts before they reach expiration. 
  • There are not a lot of contracts that we let go all the way until expiration.
  • Results show that when you exit these positions early, when favorable, it is better just to take the risk off.
  • When you are making a profit, most times it is better to take the tradeoff and bank the profit. 

Example:

SMH traded in a range between $80 and $90 during June/July, but started and ended the two month cycle at about $86. This tells you that throughout that time there were a lot of opportunities to make a profit during the movement of the range. The market ebbs and flows, which gives you the opportunity to take money off the table if you are patient enough to wait for those moves. 

*When things move your way and you have an opportunity to take money off the table, you probably should do it.

  • Often times traders get greedy and wait all the way until expiration to get as much out of it as possible. 
  • However, if you are taking 90% of the premium out of it, why hold it any longer to make another $10?

Should You Buy Back Penny Options?

Example 1: If you have an iron butterfly and sell 100 strike calls and 100 strike puts. Then bought 110 calls and 90 strike puts. If by the time you exit the position those option contracts are not worth a lot, you probably should not exit those positions. If they're only worth $1 or $2, don't spend the $1 in commission costs to close out the trade. Leave those long options on to expire worthless, so that they act as little long lottery tickets in case the markets become really volatile in the time until expiration.

*They act as a tail hedge for your portfolio against a black swan event that you cannot predict. Keep in mind, if there is value left in these options you should close them out.

Example 2: You have short option contracts where you are selling a strangle, as you get closer to expiration each leg of the strangle is worth about a penny.

Inside the week of expiration, with option contracts far out of the money, let it go to expiration.

Test: "Throwing a lure in the water"

  • To see if contracts are worth buying back, put in a order to buy back just one contract on each side.
  • If the order does not get filled fast, it most likely means that nobody is interested in that strike price level. 
  • If there is no liquidity in those far out of the money options, it is reasonable to assume that those option contracts are not close to going in the money or have a very slim chance.
  • If they did have a chance of going in the money, somebody would be buying then up, even in the last couple day of expiration.
  • Ultimately, it all comes down to determining how far out of the money your contracts are. 

Profit Matrix Research Results (see show 100)

  • When you close out of an iron condor at a 50% profit target, that is one of the best ways to increase win rates.
  • This creates positive expected returns and you experiences much lower drawdowns because you are not holding the position and letting the market go against you. 
  • In those scenarios you also have slightly lower returns at the end of a 10 year trading period.
  • Most trades that go all the way to expiration ends up generating the bulk of the potential returns. 
  • When you let the contracts go to expiration, you give up your win rate and drawdowns. 

*This is not an every market scenario.

Closed out at 50% profits: creates a stable portfolio curve, a consistent growth metric

Sent to expiration: creates a much more erratic portfolio curve with big spikes and big drawdowns — created higher returns, but a lot more volatility

  • At Option Alpha we started holding trades just slightly longer than we have in the past, to find the benchmark. 
  • However, if we have early profits we will proceed to take the trades off.

Ex: If you make a trade and it's 60 days out and 10 days into that trade you reach 50% profit target, take the trade off. It's not worth it to hold it another 50 days to possibly make another possible 25% or have the stock turn against you.

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Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
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Option Trader Q&A w/ Moe

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from Moe, who asks:

What do we do if we want to take a little bit less risk and go out to the 10 and 15 Deltas, so the probability of success is around 90%. Now the bid and the ask are extremely wide at these levels, no matter how liquid the options are, whether it be Amazon, Nvidia, Facebook, Netflix, they all have extremely wide bid and ask spreads when you go 30 to 45 days out. Currently I'm running a 75-70 put credit spread on Nvidia because it's in the 50 to 70 IV rank level and though these puts are gaining value, I actually can't sell it for a profit because the bid and the asks on both the 70 and the 75 are extremely wide. So how would you go about going further out the money and having less risk and having a great probability of success but facing these wider bid and asks spreads?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

Thank You for Listening!

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.