Wednesday, June 9, 2010

An Option Sellers Dilemma

Let's tackle a question I received from Dave earlier today.

You've mentioned before that it might not be a good idea to hold options into expiration due to gamma risk. Do you ever just let them expire worthless or do you always exit? I have two bear call spreads, one is a little over $10 OTM while the other is $15 OTM. Both are virtually worthless, but it would cost $.10 plus commission to close them. In this case would you hold to expiration to avoid commission or do you never hold into expiration?

This is a scenario that faces all option sellers at one point or another. Whether you sell covered calls, naked puts, or credit spreads, you'll eventually face the dilemma of deciding whether to buy back short options when you've captured the majority of the profit or ride to expiration in an effort to lock in the last few pennies. The obvious allure of hanging on until expiration is capturing that last $.10 plus avoiding paying the pesky commissions which are unfortunately a necessary evil. As you mention, the treacherous risk lurking in the shadows around expiration is gamma. While it seems like a "sure thing" that your bear call spreads will expire worthless, the market has a merciless track record of reminding traders there's no such thing as a sure thing. Don't rule out the chance that the stock you're trading could make a kamikaze run for your short call spread over the remaining week. Due to the high gamma of short term options, they can increase rapidly in price if they start to move close to the money.

Traders who continually hold short options into expiration will inevitably face a scenario where they end up having to buy back those $.05 or $.10 options for $1 or $2. All it takes is one huge adverse move close to expiration to wipe out the additional few bucks you gained from the past five or ten trades. After experiencing a few of these gut wrenching disasters, most experienced traders opt to simply avoid the high gamma drama that plays out close to expiration by closing short options early. They value the peace of mind that comes with this approach more than the extra few bucks they may make by riding to expiration. At the end of the day, it's really up to you as to which route best fits your risk tolerance.

For related posts, readers can check out:
Public Enemy #1
Gamma vs. Theta
Gamma vs. Theta II

3 comments:

MarkWolfinger said...

Tyler,

Good reply, but I would need more information. If the option is $10 OTM, the stock price makes a huge difference.

If it's a $20 stock, don't pay ten cents to buy the Jun 10 puts. But you should have been bidding 5 cents earlier.

If it's an $80 stock, pay that ten cents in a heartbeat to cover those Jun 70 puts - and don't give it a second thought.

If the cost of commissions is a consideration, you are using the wrong broker.

Tyler Craig said...

Hey Mark,

Agree on all points. In assessing a strategic price to close the short options, stock price should certainly be considered.

I've heard the "saving commission" rationale quite a few times and couldn't agree with you more.

QUALITY STOCKS UNDER 5 DOLLARS said...

Interesting take on options.