When Should You Buy Back The Short Leg On A Credit Spread?
Kirk Du Plessis | Oct 08, 2013 01:40AM ET
You’ve made a great credit spread trade and the market is going the direction you wanted. Congrats to you!
At this point you’ve made nearly all the money you could possibly make on the trade and you’re left with a dilemma? In this post I’m going to walk through the two major scenarios that you might encounter and how you should adjust your trade.
It’s important to remember that options trading is about controlling your risk and removing trades that show too much risk without enough profit potential. If you can do this consistently you’ll be well on your way to better returns.
Quick Underlying Move – Premiums Still High
Let’s say you sold a SPY $1 wide credit spread for $0.20 and quickly afterwards the underlying stock moved away from your spread leaving near max profit within a couple days of the entry. The spread now trades at $0.05 and you’ve banked a $0.15 profit but there is still 30+ days to go until expiration.
While this isn’t the most common of the two it does represent a big decision. Do you stick out the trade for the little premium left or exit the trade completely?
Statistically you should exit the trade completely and take your money. It’s not worth the risk for 30+ days for a small $0.05 profit.
But why wouldn’t you buy back the short leg you ask? Well, at this point you still have a lot of time left until expiration and in all likelihood the option premiums are still very high. Just because the credit has declined to a nice profit doesn’t mean it’s a good idea to close the short leg and leave yourself hanging with a long option with a huge value that could quickly drop.
If the underlying premiums are still high then you are better off to close the trade.
Long Underlying Move – Premiums Are Cheap
Taking the same SPY credit spread from above, now let’s assume the market moves slowly over the next couple weeks and you finally show the same $0.15 profit but now there is only 5 days to go before expiration. You are more likely to have this scenario play out over time than the one above.
In this instance we actually have an opportunity to lock in profits AND possible leave ourselves room to earn more money. By this time the individual option premiums are very cheap so we have wiggle room to make some adjustments.
You could then buy back the short leg of the credit spread leaving a long option left as a lottery ticket. Ideally this remaining option would only be worth a couple pennies at the most. This way if your lottery bet doesn’t pay off you don’t go negative on the whole trade in the end.
With this last long option you don’t expect to make money but you also protect the profits you have and remove the risk that IF the market moves against you in the last couple days you don’t lose the credit already banked (plus you might make a couple extra dollars if the move is big enough).
Individual Option Premiums Determine Buy Back Timeframe
As you’ve seen, deciding when to buy back the short leg on a credit spread has nothing to do with the underlying market but rather where the premiums are on the options you are trading. If they are super cheap go ahead and buy it back. If not, it might be worth waiting more or closing the trade at a profit.
What’s your take on buying back short options? Do you have a particular strategy you use? Add your comments at the bottom and share your insight!
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