It’s OK to admit it. Lottery tickets are tempting. Sure, your chances of winning aren’t that good; but the pay-off! A lot of us are willing to risk just a little bit for the (remote) chance of hitting it big. But when it comes to option trading, many traders find themselves on the other side of this logic.
Short for a Nickel
When holding option positions, waiting for them to become a profit or readying to nip losses in the bud, traders watch as the options move more in- or out-of-the-money. Sometimes options move so far out-of-the-money that they become nearly worthless, being no bid offered at a nickel. For short option strategies, this is a welcomed outcome. The less short options are worth, the greater the profit. Many traders hope to see their shorts expire worthless upon expiration. But when options are offered at $0.05 prior to expiration, it usually makes sense to cash in early.
Risk v. Reward
The least an option can be worth is zero; but they can gain quite a bit of value (theoretically infinite) if the underlying moves to make the options deeper in-the-money. When traders sell options, the max profit is capped at the price at which the option is sold. As the price of the option fluctuates, whatever the current option price is, that is the most the trader stands to gain at that point in time. For example, If a trader sells a put at $0.65 and the value of the option declines to, say, $0.50, the trader has an unrealized gain of $0.15 and stands to potentially make another $0.50 if the market cooperates. Still the risk remains that the underlying reverses and the unrealized gain is erased and losses may be incurred–maybe big losses.
When options are offered at a nickel, the most a trader stands to further gain is $0.05. But, the potential for substantial loss remains. At this point in the option’s life, it has become a "reverse lottery ticket". The trader hopes to make but a small insignificant profit while risking a potentially devastating loss if the market has a large (albeit, unexpected) move against him. Generally, it’s not worth the risk.
The solution for this disproportionate risk is simple: buy options when they are offered at $0.05. Close the position early and take the bulk of the profits. Use that margin capital more efficiently as you move onto the next trade with, arguably, better risk-reward potential.
You can contact Dan at www.markettakers.com.