A Note for the Serious Investor:
The material that follows is written for high-net-worth and accredited investors who are serious about understanding the use of commodity options in a professionally managed portfolio. Futures and options involve substantial risk of loss, are not suitable for all investors, and only risk capital should be used. This article is for educational purposes only and is not a recommendation to buy, sell, or hold any specific futures contract, option, spread, or commodity position.
I am often asked whether the objective of selling an option is to have it expire worthless.
The answer is yes and no.
Obviously, having a short option expire worthless can be a successful conclusion to a trade. If the position is part of a credit spread, the maximum gross profit is generally the net premium originally collected, less commissions and fees.
However, allowing every position to remain open through expiration may not always be the most efficient course of action. In our experience, buying back profitable option positions before expiration can provide several important benefits.
A Hypothetical Example
You sell a natural gas call credit spread, collecting $774 in gross premium. After transaction costs of $74*, your net premium collected is $700. Sixty days before expiration, the spread can be bought back for $20 including exchange related costs.
Is it better to buy back for $20 and realize a net profit of $680 or hold two more months for the final $20? Transaction costs and liquidity considered, in this situation we would generally consider buying the spread back.
There are several reasons why.
1. You Realize Most of the Potential Profit
By buying the spread back for $20, you would realize approximately 97% of the position’s maximum potential net profit. At this point, there is very little remaining profit available from the trade, while the position is still exposed to an adverse move in the underlying market. The position may still appear likely to expire worthless. However, the more important question is whether earning the final $20 justifies remaining exposed to the market for another 60 days.
In many cases, we do not believe it does. Closing the position allows you to realize the majority of the available profit and remove the remaining market exposure associated with that spread.
“The more important question is whether the final $20 justifies remaining exposed for another 60 days.
2. You Free Up Capital for Repositioning
The position may not require as much margin as it did when it was originally established, but it may still be using capital that could be deployed elsewhere.
By closing the spread, you release any remaining margin requirement associated with the position. That capital can then remain available for future opportunities in other commodity markets — or for a new position in the same market when appropriate.
This does not mean capital should immediately be redeployed simply because it is available. Any new position should still meet the same fundamental, seasonal, valuation and risk criteria used for the original trade.
3. You Book a Winning Trade
By taking profits early, you remove the trade from the portfolio. It is one less position to monitor, one less expiration to manage and one less market exposure that can change unexpectedly. This can make the overall portfolio easier to manage and allow greater attention to be directed toward positions where meaningful risk and profit potential still remain.
No Single Exit Rule
For the most part, we do consider early buybacks when they are economically practical. Options decay at different rates depending on the movement of the underlying market, implied volatility and the amount of time remaining until expiration.
Some positions may reach their profit objective several months before expiration. Others may not reach it until a few weeks before expiration. Some positions may need to be held longer, adjusted or closed for reasons unrelated to profit.
There is no single exit rule that applies perfectly to every trade.
In the managed portfolios we oversee, a buyback will often be considered when approximately 90% or more of the position’s maximum potential gross profit has been earned. If a position has decayed to 10% or below of it’s original sale price, I believe you should consider booking it.
*Transaction costs are based on approximate exchange related fees plus $35 per option contract (round turn).
