lystn

Hey everyone, Kirk here again and welcome back to the daily call. On today’s daily call, we are going to be talking about option writing strategies and exiting these positions before expiration. Today's call basically came out of a question that somebody emailed me. Again, if you have a bunch of questions about options trading or strategies and you want to email them or tweet them in or leave us a private voicemail at optionalpha.com/ask, we will definitely get them added to the list for these daily calls because we’re doing them as you know, every single day. And so, this helps me just figure out what you guys want to hear and what you guys want to learn. In this case, somebody emailed in and they said, “Hey, can you close out a trade before expiration when writing options? Do you still get the premium? How does this whole process work out? I don't really understand and it doesn’t make sense.” Here’s the deal and we’ll just take this step by step. When you are doing an options writing strategy where you are effectively selling options to open, so you sell a spread or sell a single call option or a single put option, you then have the requirement as an option seller to close that position before expiration or let the position expire. Now, I always say and the easiest way to think about this is that if the position is in the money, meaning if your strike is in the money at expiration, you need to be active in closing the position. You need to take an active role in actually reversing the trade and closing out of that position. If your strike price is out of the money which is ultimately what you want, you want your strike price to be out of the money, then you can let that option contract go through the expiration process because it will expire worthless and it won’t do anything to your account. Now, that doesn’t mean that you can’t close out that contract earlier or in advance of expiration. You don’t have to let the option contract go through the expiration process and expire worthless. You could actually go in at any point as an option seller and physically close back out of that contract. Remember, as an option seller, you have the requirement to fulfill the trade and complete the cycle to close out of that contract or let it expire worthless. Now, if an option contract is in the money or even out of the money and you want to go back in and close it, all you simply have to do is buy back the contracts that you sold. If I sold a put option at a 50 strike price, at some point in the future, I’d want to go back in and buy back that put option to reverse the trade and close the loop, close the trade cycle and take whatever premium is left. To work through a simple example here, so it helps out, if I sold a 50 strike put option on a stock that was trading at $60, then I would make money as long as that stock traded basically above $50. Let’s say I took in a $200 premium for selling that 50 strike put option. Now, if at expiration, the stock is trading at $60, I can basically let that put option expire and I keep that $200 premium. I sold that option, option contract is out of the money at expiration, I don’t have to do anything unless I want to and if it expires worthless and out of the money, I keep the entire $200 premium. But now, let’s say that it’s expiration and the stock is trading at say $51. It's close to expiration, the stock is trading at $51, I traded the 50 strike put, I'm nervous that the stock might go in the money and the stock might go down by a couple of dollars, so I might go back into the open market and buy back my put option that I sold which might have a little value left in it, maybe it has $10 of value, so I’ll pay $10 to close that contract. Now remember, I collected $200 of premium initially for selling that contract. If I buy that contract back for $10 from somebody else, I still pocket $190 of profit and now, my risk is totally gone and I’ve closed out of the contract and I’ve reversed the loop and now, I’m totally done. Again, the premium that you collect, you basically hold on your balance sheet or on your ledger, but you have to basically maintain that premium or keep it as much as possible and you can use part of that premium to go out and buy back those contracts hopefully for a lower price. The third scenario of course is that the stock is trading down below your strike price of $50. The stock is trading let’s say at $45, we collected a $2 premium, but now, let’s say that the stock ends at 45. We would have to go out and either buy that contract back for $5 which means that we have a $500, so it means we have a $300 net loss on that contract or we’d have to go through the exercise and assignment process which we’d usually don't want to go through, so we would try to actively close out that contract before expiration. Again, if the stock landed at $45 and we have to buy that contract back for $5 of value, that means that we take that $5 and the option contract value is like $500 notional value. If we have to buy that back for $500, less the premium that we collected initially of $200, again, that leaves us with a $300 loss on the position. Again, that’s assuming that we don't go through the exercise process, we try to actively close out of those positions before expiration. Hopefully that helps out. Hopefully it does answer the question. I know that sometimes it can get a little confusing, so try to write it out, try to draw it out the first couple of times that you do it. But yes, you can go through and close out those loops. That’s the way I always think about it, is that if I have contracts that are out there, to really keep the money and make sure that everything is done and the accounts closed or those trades are closed, I have to close loops. If I sell something to open, I have to buy it back to close. If I buy something to open, I have to sell it back to close to make sure I complete the full trading circle. As always, hopefully this helps out. If you guys have any other questions, let us know. Until next time, happy trading!