Commodities Roundup: Taking Early Profits with Option Buybacks

James Cordier & Michael Gross, Optionsellers.com
August 30, 2010

I am often asked if the objective of selling an option is to have it expire worthless. The answer is yes and no. Obviously, your short option expiring worthless is a successful conclusion to your trade. You’ve taken your full profit, the premium collected is yours. However, letting your option sit through expiration may not always be the most efficient course of action. As we at Liberty Trading explain fully in The Complete Guide to Option Selling, I’ve found that buying back options prior to expiration can provide a number of benefits.

For instance, let's assume you sell a Natural Gas call option for $700. Sixty days prior to expiration the option is worth only $20. Is it better to buy it back for $20, taking a $680 profit? Or is it better to hold the option for two more months, with the best case scenario being an additional profit of $20?

I would advise buying this kind of option back for the reasons listed below:

1.You take over 97% of your potential profit from the trade and eliminate your exposure in the position. At this point there is little to gain from this position ($10) and everything to lose. Chances are overwhelming that this option will expire worthless but why take the risk for 90 more days if there is nothing to gain?
2.You free up valuable margin. Chances are this position does not have much of a margin requirement at this point, but it is probably still pulling a few hundred dollars. By freeing this margin and eliminating the risk exposure, you can redeploy funds in other markets, or sell more natural gas calls as you now have no additional exposure there.
3.You book a winning trade. By taking profits early, you take the trade off the books. It is one less trade you have to monitor, one less line you have to look at each week. You free your mind and capital to pursue other opportunities.
For the most part, we do recommend early buybacks when they are viable. Options decay at different speeds depending on the movement in the underlying and time until expiration. Some may be bought back 5 months early; some may be bought back 2 weeks early; some you may have to hold through expiration.

In the investor portfolios that we manage, buybacks are typically considered when the option premium has decayed down to 10% or below of it’s original sale price. If you have made 90% or more of the potential profit on the trade, you may want to consider booking it.

Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.

James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group/Optionsellers.com
Optionetics.com ~ Your Options Education Site