Option buyers understand the pain that the passage of time inflicts upon them. I’ve always believed that the major goal for all option owners is to sell the option as quickly as feasible. When buying an option, the trader has some objective in mind, and most of the time it’s a change in the price of the underlying stock. Less often it may be based on an expectation of an increase in the option’s implied volatility. If either of those expectations comes to pass quickly, the option owner stands to profit.
Once that anticipated event occurs, it makes little sense to hold onto the option. You had an idea, it came true, the market responded. Whether the response was better than you planned (good news), or worse (sad news), the event is over, the market has moved, and there is no reason to own the option. As I said, that’s my belief.
Many option traders, especially the inexperienced, are often unsatisfied with the economic result (loss, or profit is too small) and hold, looking for the market to validate the original premise. Because the event is over, holding becomes a wager that the news wasn’t fully digested the first time, but that it surely will be enough to affect the stock price in the immediate future. Clinging to that hope day after day, the position is held, until it eventually expires worthless. If the option is in the money, all time premium erodes, and the option owner may no longer have a profit.
Holding into expiration is a difficult thing to do, especially as you watch the value of your option decay. What keeps those holders married to their options is the fact that a decent stock move can change the option’s value by a large amount in a very short time span. Once the option value has shrunk to almost nothing, it
pays to hold in the hopes of a miracle. The problem is that these options should have been sold much earlier.
Option sellers are on the other side. The passage of time is most welcome. If the stock doesn’t make an unfavorable move, the option – slowly at first, and then more rapidly – loses its value and the market price moves towards zero (for out of the money options) or parity (The option’s intrinsic value) for options that are in the money.
This time the question is not when to salvage as much premium as possible, but rather it’s when to repurchase the short position to lock in the profit and eliminate risk.
As the price of the option is decreasing, it seems natural to hold onto the short position, at least for just one more day. And that good idea can result in problems. When holding for that one extra day worked so well yesterday, it’s natural to anticipate that holding for another day is likely to bring a similar result – an increase in profits. When the option is out of the money in the morning, the probability is that it will remain out of the money when the market closes for the day.
That makes it an attractive proposition to maintain the short position. When a trader thinks that way, there is seldom any incentive to exit. It seems ‘obvious’ to hold and make more money.
Risk is ignored, with the eye trained squarely on the theoretical time decay for the day. We all recognize than an option with a two delta is going to finish in the money one time out of 50, or approximately once every four years. That’s much more frequent than ‘never.’ With so little to gain, why take the chance? It’s important to gauge just how bad it can get, if this position turns on you. The problem for most traders is that they estimate neither the potential loss nor the likelihood of that loss.
When the market has been dull and moving quite slowly, it’s even easier to think that way. But just as the option owner gets pretty good gambling odds when holding a soon-to-expire-out-of-the-money option, the trader who is short that same option is taking a big risk (with a high probability of winning) to gain a small amount of money.
I’ve been there (Chapter 5) and understand the temptation. But the potential loss does not justify taking that risk. Let somebody else have the last $0.05, $0.10, or even more for those almost, but not quite ‘worthless’ options. Yes, pulling the trigger is difficult, but over the longer term, you will be a happier, less stressed trader.
NOTE: I am NOT recommending that you pay cash to repurchase options that are 10% out of the money when it’s two days before expiration. I am referring to placing bids ($0.15 or $0.20) to buy options or option spreads when at least three weeks remain before the options expire. I’ve been able to repurchase spreads @ fifteen cents with as much as seven weeks remaining before expiration. I know that’s a good deal.
How much to bid depends on your portfolio. If you have sufficient insurance that a major move will not hurt, there is no incentive to bid more that your comfort zone dictates. I maintain insurance, so fifteen or twenty cents is about all I’ll bid for one month options. But, when I lack insurance, or when a big market move represents a real financial threat, I bid more.
My top bid, when risk was present was about one penny per trading day remaining before the options expire – with a $0.35 limit. I did that when markets were more volatile (2008-9). Today, my top bid is $0.25.
It’s your money and your comfort zone, but there should be some price – no matter how low – at which it’s a good idea to buy back those ‘cheapies.’ If your commissions are so high that you avoid these trades, you must look into using a less costly broker. Taking extra risk because trading expenses are high does not make sense.
Placing a good ‘til cancelled order with your broker is a good 'set it and forget it' routine, but I don't recommend it. You may forget the order has been entered and that can be a problem. If you work full time and cannot watch the position closely, that's a different story and I recommend a ‘good for the week’ order that can be reconsidered each weekend.
If you learn to enter an order to purchase those apparently worthless options, ask yourself: Which would make you feel worse
i) Not exiting when you know you should, and occasionally losing real money?
ii) Exiting and seeing the options expire worthless
It’s that psychological factor at play again. If you know taking a specific action could induce feelings that hinder your ability to function efficiently, then for peace of mind, avoid the choice that could result in those feelings. Remember, if you simply learn to ignore what happens after you exit a trade, there is no danger that this will occur.
Hold or exit
As expiration approaches and you are facing a ‘hold ‘em’ or ‘fold ‘em’ decision, I recommend making the best decision, with everything being taken into consideration. If holding and losing extra money represents an unhappy outcome, but folding, only to see the market ‘behave’ would be so upsetting as to hinder your trading, you would be in the bad position of being forced to take extra risk – just to avoid that ‘devastated’ feeling. Advice: consider making adjustments by reducing position size. By the time it becomes necessary to exit, the position may be small enough that exiting at the market top (or bottom) won’t feel so bad.
Obviously it’s best not to be hurt by losing decisions, but the truth is that every trader cannot do that.
Trading involves much decision-making. Do the best you can (sure, try to develop skills that allow you to make even better decisions), but learning to live with those decisions is a skill worth developing.
This post was presented by Mark Wolfinger and is an extract from his book Lessons of a Lifetime. You can buy the book at Amazon. Mark has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Mark has published seven books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
- Trader Mindsets
- How Much Can I Earn With Options?
- Trader’s Mindset: Oblivious To Risks
- Managing A Losing Trade
- Learn First. Trade Later
- Adaptability And Discipline
- Maybe The Market Will Turn Around
- Trader’s Mindset: Always Collect Cash
- The Art Of Trading Decisions
- Managing Risk For More Than One Position
- My Philosophy On Options Education
- Trade Decisions: Risk Or Profits?