canstockphoto1802347As a premium seller we naturally have to deal with trades that do not go in our favor.  In fact, we expect them!

If you trade options using the “probability based” method and you typically execute trades with at 70% probability of success, the math alone tells you to expect about 30% losers.  However, if you sell volatility (premium) when it is extended beyond its’ mean you will normally experience a losing percentage closer to 25%.

Over the course of thousands of trades by managing your winners you should expect your percentage of losing trades to be in the 25% area.  Remember that every losing trade is not necessarily a maximum losing trade.

To illustrate this let’s take a look at a simple vertical credit spread and discuss our options for trades that are not profitable:

  1. Price of underlying has breached the long option (full loser)Exiting ITM Spreads

In this example the spread was sold for a credit of .42.  The vertical spread risk is $1.00 (difference between short 13 put and long 12 put).  The underlying is currently trading at 10.37.

This spread is a maximum loser.  The trader has two choices:

a.  Do nothing and let the broker close the trade

If the position is 5 or more spreads, then “do nothing” and let the broker (TOS) close the position.  The trader will incur a $15.00 per strike assignment fee (total $30.00 on a vertical)

1-Lot $100.00 + $30.00 assignment fee = $130.00

5-Lot $500.00 + $30.00 assignment fee = $ 530.00

b.Manually close the trade

If your position is less than 5 spread trades you may considering closing the position manually and avoid the assignment fee.  Let’s look at the math

Close spread at 1.05 (maximum you should have to pay)

1 lot – $105.00 plus commission $3.00 (2 legs) = $108.00

5 lot – $525.00 plus commission $15.00 (10 legs) = $540.00

This illustration shows you that the breakeven for manually closing these positions is approximately a 5 lot.  This example is based on my broker of choice, Think or Swim (TOS).  If you use another broker it is suggested you find that broker’s policy and fee structure on assignments and make an evaluation of what is the optimum financial decision.

Note:  If you are a small lot trader, I would suggest that you do “price discovery” to exit at the most efficient price.  On expiration day I typically start out trying to buy a $1.00 wide spread back for $1.00, then if not filled, I will use the “cancel and replace” function to raise my bid in .01 increments.  If you are trading highly liquid products with tight bid ask spreads the maximum you should have to pay to exit is .05 above the spread risk (or $1.05

The procedure is exactly the same for wider spreads.  The math does not change.  Start bidding at the spread risk and incrementally increase the bid by .01 until the position is closed.

Experience has taught me that you can usually get filled at or near the spread risk early in the day.  If you choose to wait until late in the day to see if the market moves your spread more favorably then expect to pay the spread risk plus .05.

Here are recommendations for the other ITM vertical spread scenario:

  1. Price of underlying is between the short and long strikes
    1. You have to be proactive if the price of the underlying security is between the short and long strikes. If you do nothing you will be exercised at the short strike and the long strike (which has value) will expire and you will not receive the proceeds that you could have realized from the sale of the long option.
    2. To exit this trade I suggest you initially attempt to buy the spread back at “mark” or the short strike minus the current price of the underlying instrument, whichever is lower
      1. Example: 13/12 put credit spread. Underlying is trading at 12.61.  The value of the spread is .39 but don’t expect to be able to close it at that price.  There will still be some extrinsic value in the options.  Expect to pay slightly above the value of the spread.
        1. As the day progresses the extrinsic value will continue to come out of the spread. However, no “hero crap”!  Don’t wait until the last minute of the day.  Exit and move on.

If you have any questions regarding how to properly exit option trades that have gone against you, don’t hesitate to call me……239.272.3424…..I Answer My Own Phone!