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Keeping Your Short Options Position Until Expiration: A Good Idea?

Introduction

Managing your trades or adjusting them to reduce your risk is essentially what the whole concept of successful options investing is all about. When I occasionally sold covered calls on my buy and hold stocks, I didn't even think about exiting my trades before the expiration date. It wasn't put on my calendar because I wasn't aware of what's known as gamma risk. The purpose of this article is to elucidate the mystery behind it and why so few options traders understand its devastating power.


Delta and the velocity of time decay

You probably are familiar with time value erosion which makes options a wasting asset. Period. Most people will tell you that this process accelerates heading into the last two weeks before expiration Friday, but depending on what delta your short options have, that statement is not accurate. Let's focus on the following chart, which depicts a 10 delta put option on an underlying with 23% implied volatility and a share price of 140.67 dollars. Because of its already low delta and thus low probability of ending up in the money, time decay is actually going to slow and has an inflection point just 6 days after having sold the 32 DTE. So, the rate of daily theta decelerates throughout the life cycle of a 10 delta option in case of no changing volatility and stable share price.

(Source: own research)


That implies you will pocket 80% of your options credit within 17 days with 15 DTE. That cash can then be redeployed on other opportunities such as earnings plays.

(Source: own research)


Selling the 30 delta option gives us a totally different picture: a continuously increasing rate of time value decay before it suddenly starts to fall off a cliff. The inflection point lies at 11 DTE.

(Source: own research)


Because of a pretty constant time decay, the 30 delta puts will reach 50% of max. profit halfway the 32-day cycle.

(Source: own research)


The ATM puts (50 delta options) are the most intriguing: an exponentially growing time decay with a huge acceleration taking place 5 days before expiration.

(Source: own research)


ATM options will retain their value the longest because there's a 50% chance of ending up in the money or out of the money. Just think about it as the last minute of a football game when everybody gets nervous. 5 days before expiration, the option still has 37% of its original value. Heading into the last few days before expiration is a binary event for option sellers and it's unjustifiable to keep ATM options (or options with a delta of more than 35) positions open until expiration. These last 5 days determine whether your trade is going to be a losing game or not. Don't take that risk but roll the options out instead.

(Source: own research)


Tasty Trade did a lot of research on gamma risk and the benefits of rolling out your options positions to the next cycle. They examined the options Greeks on the S&P-500 and found out that the ATM options can go from a delta of 50 to 90 in just 3 days before diving toward a delta of 30. ATM options are so sensitive to changes in the share price of the underlying.

(Source: tasty trade)


Managing winners & rolling out in time

Managing winners at 50% of max. profit is a particularly appealing approach to reducing your portfolio risk, benefitting from a collapsing implied volatility and rebalancing your positions. But what if we don't reach 50% of max. profit 15-10 days before expiration? Because of slowing time decay for out-of-the-money options, it doesn't pay for us to still be in the trade. In fact, we're taking on more risk (gamma risk) for less reward (lower theta & Vega and we're longer in the trade). Because of the binary aspects of expiration, by closing out earlier and simply rolling to the next cycle, we rule out the risk of struggling with big losses. Let's focus on the following table containing a Tasty Trade study of 4 years.


(Source: Tasty Trade)


We can deduct three crucial elements from this study.

  1. Your biggest loss - when managing winners and in case 50% isn't reached before 15 DTE, you close it no matter what the result is - amounts to 3,473 dollars versus 9,740 if you held until expiration.

  2. Your average P/L per day is a lot higher when managing and closing early. Less reward and more risk if you wait until expiration.

  3. Your win rate is 86% for managing and closing early versus 79% if you don't take action.

These results are worth mentioning as the strangles were sold in every IV environment, so without looking at IV rank your profit metrics still blow away holding until expiration. This is just fascinating as most option sellers gamble on their options trades being profitable at the end of the cycle. You take on more risk and ruin your daily P/L figures.