Maximizing returns in any type of investment is a critical philosophy whether it be securities, real estate, or a business.
Options trading is no different, as traders seek to leverage the most efficient risk-reward ratio possible when executing, managing, and closing trades.
Expiration is a critical period for option traders as contracts inch closer to ultimate settlement value - meaning careful management of these positions can help drive increased returns alongside minimized risk.
This very topic was discussed on Market Measures recently and today on the blog we are focusing on this dynamic subject.
One key consideration regarding expiration is deciding when one should close a position - or more specifically - is there an optimal window of time to close an options trade prior to expiration?
Tom Sosnoff and Tony Battista, the hosts of Market Measures, present some key studies done by tastytrade that can help provide an answer to that question.
It's important to remember that as options get closer to their expiration day, the theta decay of out-of-the-money (OTM) options will slow. This is a result of lower absolute option prices and tail risk (sudden, outsize moves).
Depicted below is the graphical representation of slowing decay for OTM options:
The slowing of decay alongside lower absolute option prices is the definition of a declining risk-reward ratio. Lower option prices mean the reward side of the equation has collapsed, while we still hold the same risk profile from the original trade... this is especially true of short premium structures.
In order to better understand this declining risk-reward ratio in terms of options approaching expiration, the tastytrade team ran studies on SPX options using the following criteria:
- 2005 to present using a total of 1012 observations
- Sold one standard deviation strangles in SPX (16 delta on each leg)
- Used the expiration closest to 45 days-to-expiration (DTE)
Analyzing that data, the Market Measures team discovered that by closing a position two weeks prior to expiration, a trader's theoretical percent of profitable trades increased to 85%. The analysis of the results are depicted below:
As you can see above, exiting a position two weeks before expiration (on average) allowed a trader to access the highest percent of winning trades as well as the highest P/L per day. However, the trader did have to sacrifice a portion of the total average trade P/L.
It's important to remember that holding a trade all the way through expiration also has capital ramifications. By closing the trade two weeks before expiration, a trader can redeploy into another attractive position rather than waiting for that final piece of decay.
Further research by tastytrade on this subject provides additional evidence that the two-week window does help with trade and capital efficiency.
On average, profits only increased by 3% by holding a trade through the last week of an option’s life and only by 16% for the last two weeks. This means that on average we collect 84% of our profits during the first 30 days of the trading cycle.
Even more interesting is the fact that 97% of profits are collected, on average, prior to the week of expiration.
The above means that the headache that can often come along with managing option positions during that last week of expiration may not be worth the stress nor the time. By closing positions whose performance is beginning to slow, a trader can redeploy capital into more attractive positions while avoiding a declining risk-reward ratio.
We hope you'll watch the entire episode of Market Measures focusing on exiting positions before expiration when your schedule allows.
Please don't hesitate to contact us with any questions on the expiration topic at firstname.lastname@example.org
We thank you for being the most important part of the tastytrade community!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.