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 how 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.
Example: 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.