by Russ Allen, Online Trading Academy Instructor
Occasionally, I use one of these columns for answering questions that readers ask. We have a couple of interesting ones today.
I heard that when I sell an option short, I should always immediately put in a good-til-canceled order to buy to close it at $.05. I have observed that some option contracts do not reach $0.05 until late on expiration Friday afternoon, while others have reached $0.05 a week before expiration. My question is, “Why do we buy back our option contracts at $0.05 instead of allowing them to expire?”
Your question has two questions in it:
- Why don’t we always just let our short options expire?
- Why do we choose $.05 as the buyback price?
As to the first, remember that when we sell an option short, the maximum profit we can make is the money we received for selling it. In any premium-selling situation (short-selling of options), we are counting on time to erode away the value of the option(s) we sold, ideally to zero.
As you noted, sometimes the option doesn’t lose all of its time value until its expiration (and of course, sometimes the option goes into the money and it never goes to zero at all). But sometimes the drop to near zero happens much sooner, owing to stock price movement and/or a drop in implied volatility.
In cases where we have already made our maximum profit (option value has gone to zero) with time remaining in the option’s life, there is an opportunity cost to remaining in the position any longer. The cash or stock that we’re using as collateral for the short option is tied up as long as the short option exists.
If instead of keeping the position, we buy back the option for a few cents, then our collateral will be freed up, so that we can use it elsewhere. For example, we might then sell the following month’s option, (which at this point always has more than a month to run), and begin earning income again. This is called “rolling out” the option position.
Stretching this a little bit, we can see that there might be an option value above zero where it would profit us more to roll out early than to hold on until expiration.
Say we sold an option for $.75 when it had 28 days to go. In 22 days its value has dropped to $.05. Price of the underlying hasn’t changed. We now have 6 more days to wait to gain that remaining $.05. If we wait and allow that option to expire, we will not be able to re-deploy that capital until the following Monday, 9 days from now.
Meanwhile, the following month’s option might be selling for, say, $.90, with a Theta reading of $.02. It is losing $.02 per day in time value now, and this rate accelerates. That option will lose more than $.16 of value by the Monday morning following expiration (6 days to expiration plus 2 days for the weekend = 8 days, times $.02 per day). Subtracting the two cents per share in commissions it will cost us to roll the options, we could net $.14 a share on the new option by Monday morning. This is almost three times the $.05 that could be made by just letting the old one expire.
This effect is enhanced, of course, by the fact that time decay occurs every calendar day, including weekends. Any time we let an expiration Friday go by without putting on a new position, we are throwing away over two days of time value.
As to the second question, this is simply a rough rule of thumb that is easy to remember and implement, and will be mostly right most of the time. The idea is that by the time an option has reached five cents in value, it will usually be the case that the following month’s option will lose more time value than that 5 cents, in the time representing the remaining life of the front month option. We make more money by rolling out, when there is very little left to make in the existing option position. The correct time to do this is whenever the new month’s option pays more than the current month’s option, in the current month option’s remaining life plus the weekend. If you used 5 cents for the current month’s option as the trigger, you’d be close enough to this to make it worthwhile.
Some trading platforms allow you to select what type of price activity at the stop price is required to trigger the stop. What trigger types should we use for option trades?
The answer depends whether your trigger is based on the underlying price, or on the option’s price.
In most cases, our protective stops should be based on price action of the underlying asset. For example, we sell a $120 strike put option on a $125 stock, because we see a strong support area at $121. If the stock’s price drops below $121, then we were wrong in our opinion that the support there would hold, and we should exit right away. We don’t know now just what the price of the put will be when and if the stock is at $121. That depends on how long it takes, and how implied volatility changes in the meantime. Since we don’t know what the price of the option will be, our stop has to be based on the price of the stock. In that case we should use the trigger type that we should generally use on stocks: Double Trade Tick within NBBO. This means that the stock has to actually trade, not once but twice in a row, at a price at or worse than the price indicated in our condition. That’s the “double trade tick” part. It’s designed to filter out a single stray erroneous trade print. And when those two trades occur, they must be at or above the inside bid for the stock at that time, and at or below the inside ask. That is the “within NBBO” part. NBBO means “national best bid and offer.” This part is designed to filter out trades that are far away from the current market. This might be because of delayed prints or other negotiated trades away from the market price.
Although most stops should be based on the underlying price as noted above, some stops will be based on the option’s price. For example, say that we have sold a put option, and we want to buy to close it automatically in either of two different circumstances. The first is if the stock price goes below our stop, as above. The second is if the value of the option itself reaches a small amount, say $.05. At that point, we want to take most of our profit and move on.
In this case, we could enter a single order, to buy back the option at market, with two separate conditions (the Tradestation platform calls these conditions “activation rules,” while other platforms refer to them by some variation of the term “conditional orders”). Here, one of our two conditions would be based on the price of the stock, and we would use the “double trade tick within NBBO” trigger for that one. The other condition would be based on the price of the option, specifically that the price of the option goes to a point where it is at or below $.05.
This second condition, using the price of the option, needs a different kind of trigger. We should not use the “double trade tick within NBBO.” The option bid and ask prices go up and down as the underlying stock’s actual trade prices move. There may or may not be any transactions in a particular option for an extended period of time, while the stock price moves considerably. When we’re waiting, for example, to see if an option could be bought back for $.05, what we want to know is whether there are any orders that offer the option at that price. The instant there are, we want to buy the option back, whether there have yet been any trades at $.05 or not.
For the condition based on the option price, the condition itself (or activation rule) should be that the price of the option is below $.05; and the trigger type should be “single bid/ask” if we are buying to cover. That trigger will release the order if there is a single order sent in by someone else that offers the option at $.05 or less, whether there is a trade or not.
If instead of an order to buy back a short option, we were entering an order to sell an option based on the option price, then we would use a different trigger – “single ask/bid.” This would trigger our order if a single order was sent in by someone else that bid to buy the option at a price that fit our specified condition. Below is a screen shot demonstrating how this would be done on the Tradestation platform.
In this example, we are already short a December 120 put on GLD. At the top of the screen in the order bar is an order to buy to close that put at market. The Activation Rule box is checked, indicating that this is to be a conditional order. In the box in the center are the “activation rules,” or conditions.
The first condition is GLD <= 121.00. This condition uses Trigger Type Double Trade Tick within NBBO.
The second condition is GLD 131221P120 <= .05. This condition use trigger type Single Bid/Ask Tick.
This single order will automatically exit from the trade if either a) our profit objective is reached (price of the option drops to $.05); or b) our stop condition is met (GLD below $121.00). This is now a set-and-forget trade.
In summary, when entering option orders that are conditional, we need to use different trigger types when our condition is based on the underlying’s price than when it is based on the option price. For the stock, our best choice is Double Trade Tick within NBBO. For the option, it’s Single Bid/Ask Tick when we want to buy the option, and Single Ask/Bid tick when we want to sell it.