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It's easy to worry about when to exercise your trades.
Especially when you're new to options trading.
If you exit your position too early, you could miss out on huge profits. But if you wait too long and the stock ends up "in the money," then there's a chance that the options will be exercised, and you'll be assigned the shares.
The key is knowing when to make your move.
And while normally I'm happy to take a double on my trades right away, there are times when it pays to wait all the way until expiration.
Let me show you the perfect example…
Waiting Until Expiration Could Deliver the Greatest Rewards
When you're looking at the type of volatility that we've seen all year, the idea of holding a position right up until its expiration date may not seem like the best idea.
Many traders believe that in-the-money options have a greater risk of getting assigned at expiration, which means that they'll need to cover the cost of the assigned shares. And this can drive them to exit their positions before expiration.
But we're going examine how this really works using a bull call spread – or loophole trade – as our case study.
Remember, a bull call spread is a bullish strategy where you buy calls at a low strike price while simultaneously selling the same number of calls at a higher strike price. The calls all have the same expiration date.
In the case of an in-the-money bull call spread, the calls that you sold at a higher strike price would normally get exercised, and the stock would normally get assigned to your account. However, since you also bought calls to hedge against the ones you sold, these should be exercised at the same time and at the same strike price.
And the best part…
Since there's no transaction cost for this trade, your account is credited the amount of the spread (per contract) minus the cost of the calls you bought when you opened the trade (or the debit).
Let's get started…
We're going to look at The Priceline Group Inc. (Nasdaq: PCLN) PCLN Feb. 19, 2016, $1,130/$1,140 Call Spread for two reasons:
- The pattern and statistics Money Calendar gave me showed an average upward price movement in nine of the last 10 years using an end date of Feb. 25. This means that for 90% of the time, PCLN has made a bullish move by Feb. 25. For this reason, the expiration date we're using is Feb. 19.
- PCLN has a recent history of strong price movements after its earnings reports are released.
Now, we opened the trade with a debit of $4.00 (or $400 per contract). Since this is a call spread, we bought-to-open the $1,130 calls and sold-to-open the $1,140 calls simultaneously on the same ticket.
To maximize our profitability on this trade, PCLN needs to be at least $0.01 in the money at expiration. If this happens, then we're looking at a reward potential of $6.00 when the trade is executed.
Below is an image of this trade. To make things even easier, I've numbered the graph as follows:
- The date the trade was opened
- The sideways movement and subsequent drop before PCLN's earnings announcement
- The price pop after the earnings announcement
Remember that for every position you take on a trade, there's someone else on the other side of that trade.
So to close this position, we'd actually have to reverse our orders by selling-to-close our $1,130 calls and buying-to-close our $1,140 calls simultaneously on the same order ticket.
And this is when a lot of beginner traders – especially those who are new to spreads – feel compelled to close the trade before the expiration date. Understandably, many fear that the options will get exercised, thereby assigning the stock to them.
But here's why being patient and not shutting this trade down early pays off…
Take a look at where this trade stands right now:
If we were to sell-to-close the $1,130 calls, we'd get $102.40. If we were to buy-to-close the $1,140 calls, we could get them at $96.60, resulting in a credit of $5.80 to the account. Subtract the debit of $4.00 to open the trade and we're looking at a profit potential of $1.80 – which is a 45% return on investment (ROI).
That's not bad…
But when we're this far in-the-money, the likelihood of the stock remaining above $1,140 at expiration is pretty high. And if this happens at expiration, the trade will be closed, and we'll get the difference between the strike prices that we bought and sold the calls – $10.
This means that we're debiting the $4.00 cost to open the trade from our $10 credit, resulting in a profit of $6 per contract (or $600).
This is a 150% return on investment compared to the 45% ROI we would have made by closing this trade before expiration.
And with a number like that, it pays to be patient.
This Could Be Your Best Risk-Management Technique: The New York Stock Exchange is eliminating stop orders on Feb. 26, but that's no reason to worry. We've got an alternative risk-management strategy has loss protection built right in – plus a trade that'll reduce your risk even more…
About the Author
Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.
With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.