Credit spread inquiry: Here is a question that comes after reading Lesson 2 in my 9 Lesson course on selling options.
When you say, to buy back the option before, the expiration date, don’t you incur additional costs, that reduce your profits even further?
Good question. In some trades like the Calendar spread you have to buy them back because you don’t want to get long the option. But in an iron condor or credit spread, you can wait and let the options expire. If you buy them back you incur commissions plus whatever you are buying it back for.
Option trading analysis
In many cases it is a question of risk vs cost. if there is a lot of time left before expiration, you are probably best buying the trade back in case there is a move against you and you end up losing money. On the other hand if you let it expire you can save a few dollars and maybe 1 or 2% points on the trade.
So lets say you it will cost you $20 to buy back a trade, but if the trade moves against you, you could lose $1,000. Do you take your profits or hope for that last $20. Even if the trade moves just once against you in 4 years, you still lose money.
Here is a real life example.
On October 12, 2009 I did a credit spread on AAPL. I Sold the Nov 165 Puts and Bought the Nov 160 Puts as protection for a credit of .50 on each spread. There were about 40 days to expiration.
On this trade if the puts expired worthless I would make 11.11% before commissions. (Credit of $50 divided by max loss of $450 per spread = potential return of 11.11%)
Well AAPL just had earnings yesterday and the stock shot up to about 200 today. This morning, I was able to buy back the credit spreads at .07 each.
So I made .43 per credit spread in 8 days. That is 9.5%
Why did I buy the spreads back? I could have let them expire worthless. If I did i would make another .07 per spread. But there is still 31 days left to expiration. So I decided to make my profit and money and look for another trade.
Apple credit spread
Who knows? Maybe AAPL will settle down and I will sell another credit spread on it this month for more credit. Or maybe I will do something else. All I know is that I don’t want to risk losing $450 per spread (anything can happen and APPL could drop in price) to make another $7 per spread.
Yes I did pay the commissions by buying the spreads back. But on each spread I paid $2.50 in commissions. $2.50 going in and $2.50 coming out which is a total of $5 in commission per spread. So instead of mkaing $43 per spread I made $38 per spread which is still 8.44%.
(That’s why having an option friendly broker is so important. I pay $1.25 per option with no trip charge. If you are paying $10 plus $1 per option or some other crazy commissions then you ae playing a game that is stacked against you. Get a better broker.)
In my opinion, take off your spreads when they are close to worthless if there is alot of time left. Take your profits. Everyday your money is out of the market is a day you cannot lose it.
This is not to say I never let my spreads go to expiration. Sometimes I do, but not too often on a highly volatile stock.