Question - Closing Options Early

When writing puts (naked puts), do you ever close a profitable trade early? Or is it better to allow the options to expire worthless? If you do buy back a naked put early, what criteria do you use?

Answer

Terrific questions.

Yes, in fact, it does sometimes make sense to close a profitable naked put (or covered call) position early.

Now, I don't have an exact "closing options early" formula, but I can tell you what I look at and what I factor in when considering closing out a profitable trade early.

When I initially sell, or write, a naked put, I make a couple of calculations:

• First, I figure out my maximum gain in dollar terms should the option expire worthless and divide that by the total number of days between now and expiration. That tells me how much on a per day basis the trade will net me if the option expires worthless (note: this is not the same as theta, or the daily time decay of an option - this is just a quick overview of the maximum daily average the trade could net you over the entire holding period).
• Second, I also calculate my annualized returns for the trade assuming it produces its maximum gains by finishing out of the money (and therefore worthless) at expiration. This is a reasonably easy calculation: (Net Premium Received/Strike Price) x (365/Holding Period of Put).

So, for example, suppose the wonderful XYZ Zipper Company is trading around $27/share and I would really love to buy it for under $25/share. I end up selling, or writing, a put at the $25/strike price expiring in 3 months for $0.90/contract, or $90 in cash.

To keep the example very simple, we'll exclude commissions and assume that expiration is exactly 90 days away. So the net results of this trade, should the stock stay above $25/share and the put expire worthless, are:

• $1 per day in profits ($90 divided by 90 days).
• 14.60% annualized return [$90 divided by $2500 at risk multiplied by (365/90)] - note: sticklers might argue that I didn't really have $2500 at risk but rather that the outlay was actually $2410 after I subtracted the premium received - technically this is true, but I prefer just using the straight strike price.

So how do I decide if and when closing options early is a good idea?

As I said, I don't have an exact formula for closing a trade early. Rather unscientifically, I tend to just eyeball it based on where the position is, how much time remains before expiration, and maybe what I expect the stock or the market in general to do in the short term.

Now we already know that my maximum profit in the example above is $0.90/contract over 90 days. And, as you may or may not know, all else being equal, the closer an option gets to expiration, the more rapidly that option loses value (the very basis and justification for calendar spread trading and why it's a viable trading strategy).

But what happens if the stock makes either a big move higher or just rises steadily for a few weeks? Suppose that 30 days after I set up the position, the stock is now trading at $32/share. In such a scenario, my short or naked put might have only $0.20 worth of premium remaining on it.

It's at this point that I start running the numbers. Again, excluding commissions, I see that I've already gained around 75-80% of my maximum gain in just 30 days, or one-third of my original anticipated holding period.

Re-running my original calculations, I find that if I close the transaction early, I can lock in a $2.33 per day profit ($70 divided by 30 days), and my annualized return jumps from 14.60% all the way to 34.07%.

And if I look at the maximum potential profits remaining on the trade over the next 60 days, I'm only looking at $20, or $0.33 per day and a corresponding 4.87% annualized rate.

Given those numbers, I might find it very tempting to close my position early.

Sure, closing options early means you leave some money on the table, but if you can get the majority of your maximum potential profits in a short period, why hang around? That only gives the trade more time to reverse and turn against you.

More importantly, don't forget that, in this example, closing options early frees up capital for you to deploy on other opportunities.

In the end, it all comes down to your own preferences and comfort level. There's no universal answer to closing a naked put or covered call early. But, as part of good trade management, it's important to monitor your trades so that you can make an informed decision.

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