The Buyback – Taking your Option Selling Profits Early
I am often asked if the objective of selling an option is to have it expire worthless. The answer is yes and no. Obviously, your short option expiring worthless is a successful conclusion to your trade. You’ve taken your full profit, the premium collected is yours. However, letting your option sit through expiration may not always be the most efficient course of action. After trading over a million option contracts in my career, I’ve found that buying back profitable short options prior to expiration can provide a number of benefits.
For instance, let’s assume you sell a Natural Gas call option for $700. Let’s further assume that sixty days prior to expiration, the option is worth only $20. Is it better to buy it back for $20, taking a $680 profit? Or is it better to hold the option for two more months, with the best case scenario being an additional profit of $20?
I would advise buying this kind of option back for the reasons listed below:
- You take over 97% of your potential profit from the trade and eliminate your exposure in the position. At this point there is little to gain from this position ($20) and everything to lose. Chances are overwhelming that this option will expire worthless but why take the risk for 60 more days if there is little or nothing to gain?
- You free up valuable margin for repositioning. Chances are this position does not have much of a margin requirement at this point, but it is probably still pulling a few hundred dollars. By freeing this margin and eliminating the risk exposure, you can redeploy funds in other markets, or sell more options in the same market, as you now have no additional exposure there.
- You book a winning trade. By taking profits early, you take the trade off the books. It is one less trade you have to monitor, one less line you have to look at each week. You free your mind and capital to pursue other opportunities.
For the most part, we do recommend early buybacks when they are viable. Options decay at different speeds depending on the movement in the underlying and time until expiration. Some may be bought back 5 months early; some may be bought back 2 weeks early, some you may have to hold through expiration.
In investor portfolios that we manage, buybacks are typically considered when the option premium has decayed down to 10% or below of its original sale price. If you have made 90% or more of the potential profit on the trade, you should consider booking it.
James Cordier is author of McGraw-Hill’s The Complete Guide to Option Selling (3rd Edition, 2014). He is also founder and head trader at OptionSellers.com, an investment firm specializing exclusively in writing commodities options for high net worth investors. James’ market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television News and CNBC. Michael Gross is co-author of The Complete Guide to Option Selling and director of research at OptionSellers.com.
If you would like information about managed option selling accounts directly with Mr.Cordier, Mr.Gross and OptionSellers.com, you may request a free investor information pack at www.OptionSellers.com/InfoPack. You may also request a complimentary consultation by calling 800-346-1949 (813-472-5760 from outside the US).
Price Chart Courtesy of CQG, Inc.
***The information in this article has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.