I've got a related question [to this post].
I know, from this blog and your excellent book, that you recommend not
waiting to extract the last few pennies from a winning short options
Many of us have simple rules to close winning positions, such as when
the option premium has lost 75% of its value or when the option premium
drops to $0.10.
I'm trying to formulate a more formal system for this.
A CSP [cash secured put] example:
I originally sold a far out of the money SPX put option for $1.10 with
49 days to expiration. This gives a potential profit of $2.24/day.
Currently the option is priced at $0.25 with 27 days to expiration.
This gives a remaining potential profit of $0.93/day.
The daily profit available has fallen by 58% – is there some figure or
formula to indicate when it's time to close the trade?
Steve, I don't believe you will be able to mathematicize this to produce a formula. My guess is that you will be forced to rely on a 'gut feeling' of how much reward remains and the perceived risk of attempting to earn that reward.
Why? Residual time decay is very dependent on implied volatility. That alone can make theta change significantly during any given trading day.
Also, theta accelerates as expiration draws near. The fact that you own a position with decreased theta tells you that the trade is a winner. The value of the spread (or single option) that you sold has lost more value than the original daily expectation.
Thus, you already won the major part of the theta wager – time passed and nothing bad happened.
You are also winning the OTM wager. The underlying has not moved near enough to the strike price to produce an option with a high theta. In other words, it's far enough OTM that you have a winning trade.
Decision: Have you won enough, or do you like your chances to increase those winnings? I know that unlikely events happen and conservatively exit spreads at low prices. That philosophy may not be appropriate for you, but attempting to remove judgment and substitute a formula does not seem right from my perspective.
I cover based on cost and time remaining. The cost of the spread is paramount to me. Low cost means high risk and little to gain
You look at it differently. Mesmerized by time decay, and the fact that it accelerates near expiration, is important to you. And I get it. You took the risk of holding until 'now' so you want to hold when 'potential reward' accumulates more rapidly. You (correct for your comfort zone) don't care that the reward is tiny. You care about time decay.
That's not viable to me, but if it works for you, that's just proof that all traders don't think alike.
Remember this 'problem' occurs when the spread is OTM. If your shorts were much nearer to being ATM, the time decay would be much higher. Does that mean you always hold – because decay becomes so attractive?
If the answer is yes, then consider trading front-month iron condors all the time – with their high risk and high potential reward. That's consistent with searching for a formula to find an exit point based on theta alone.