Friday, June 19, 2009

Buy Back Credit Spreads Or Let Expire?

When you sell a credit spread you take in an initial credit by being short a strike and being long a more out of the money strike. Usually I take credit spread trades in the front month or second month expecting for Miss Theta to work her magic as time decay accelerates in the final month of an options life.

With that said there is always a question of whether you should hold your position to expiration realizing the full credit and saving on commissions if the spread goes to 0, or buy back the spread lower after you have gained a significant amount of the possible profit (80% or so of the initial credit).

It definitely varies by circumstances and potential catalysts on deck for the underlying but I would say that it is almost ALWAYS beneficial to cover your spread for gains before expiration if you are just trying to collect the final few nickels or dimes. If you have ever heard the expression, "Picking up nickels in front of a steamroller," then you should know that the holding out for the last dime when other opportunities are a passin' is going to eventually result in a situation like what happened in POT this week.

So what happened? As you can see in the chart Potash (POT) has been a hot stock the last several months. However just this week the company came out with news that pricing power will fall and thus the stock fell out of bed Wednesday morning. After being above 110 the day before, the stock closed that day at around 95 slicing thru its 200 day ema.

In mid May I sold a June 95/90 put spread for $1.65 and the trade worked well right out of the gate (of course in hindsight I should have just bought calls since the rally was huge). I then covered the spread at .20 in early June with still two weeks until expiration thinking that holding out for the last few dimes was greedy. This turned out to be the right move as the collapse in POT this week would have wiped out a majority of my profits.

I am not trying to gloat but simply point out that the next time you ask yourself whether or not you should cover your short credit after a nice gain; just do it. The risk/reward of holding out for the last few pennies is rarely worth the opportunity cost of missing that other mover on your radar screen so take those profits and move them into the next trade.


Mark Wolfinger said...

I'm with you.

I've been in this business for more than 32 years and I can tell you that failing to cover a short for a tiny price is losing strategy.

You make the good money and let someone else try to get the last few nickels.

Jano said...

Hi Jason,

Great informative blog. Thanks for sharing. An unrelated question: What charting software do you use for your stocks and options (the one that appears in most-if not all-of your post images)?


Jason said...

I use the Think or Swim platform which includes Prophet charts as you see.

Thanks for reading.