High probability Trading – Avoid Delta Exposure in Expiration Week
Frank Fahey
An integral part of every trade is the point where you exit the position. Every trader hates to leave money on the table and being able to choose the optimal time to close a trade can make a big difference in your profitability. Most of the strategies we teach at Discover Options Mentoring involve spreads. We have found that the best time to exit a strategy with front month options is seven or eight days prior to expiration of a short-term option – both short and long.
Most spread strategies involve simultaneously selling and buying options. Strategies with short options are the most profitable when they close at the short strike price. All of us have looked at a position and have been enticed by the trader’s tease: "If the price of the underlying closes at the short strike, then I will make $X more at expiration".
When you fall for the siren call of the increased profits during expiration week, you are ignoring the increased risk which comes with the potential profits. The increased risk comes from the delta exposure of the short option combined with the possibility the underlying will not expire at the short strike.
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To better illustrate what I am talking about, we will first review the source of the potential profits. We will then look at the risk and potential pitfalls of keeping a short front month option position through expiration week.
Options – both puts and calls – are depreciating assets. The extrinsic (time) value of an option decays at an accelerating rate as the position approaches expiration. Figure 1 below is a graphical representation of the behavior of time decay (for teaching purposes all the inputs to the option pricing model, with the exception of days until expiration, are held constant).
Figure 1
Notice that the decay slope for days the last four weeks of the expiration cycle is much steeper than decay slope for the 30-60 day period. It may be the short option is part of a spread which includes long options in the present or future months, but looking at the behavior of the short option on its own will help you understand the risk/reward for the total position. Let’s look at the theoretical price of a short Russell 2000 ($RUT) 660 call option over the five weeks before expiration with the underlying at $660 (perfectly at-the-money) and implied volatility at 25%.
| |
|
|
|
|
|
EXIT |
|
| Days until expiration |
35 |
26 |
18 |
9 |
8 |
7 |
0 |
| 660 Call Price |
24.60 |
21.10 |
17.10 |
15.45 |
13.75 |
12.40 |
0.00 |
| Profit |
|
$350 |
$750 |
$915 |
$1,085 |
$1,220 |
$2,460 |
| Remaining Profit |
$2,460 |
$2,110 |
$1,710 |
$1,545 |
$1,375 |
$1,240 |
$0 |
Looking at the decay of the call over the expiration cycle, the decay of the first four weeks is $1,220 which is your potential profit. Note that if you continue to hold the short option you could in fact make as much as $2,460, which would be an additional $1,240 in profit. In other words, if you continue to hold the position you have the potential to make as much in the next seven days as you made in the previous four weeks! It is this additional profit that causes traders to be lured into holding their positions too long. It seems like there would be a high probability of easy money in a short time. That makes it difficult to be disciplined and close your position.
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However, that remaining profit must be balanced against the risks associated with increased delta exposure. It is possible you could capture that additional profit, but just as likely you will not, plus a good chance you could give back all you your previous hard-won gains. This is best understood by looking at a risk graph (Figure 2) for the last week of this short call option.
Figure 2
Note that a move of only 3% to ~680 to the upside negates all the profits made with the short options over the previous 4 weeks. In times of high statistical volatility this sort of move in a single day is very common. If this short option is combined with a long option in a spread, the long option may offset some of these losses. But even then further moves to the upside could erase this effect and still end up creating an overall loss. It should be noted the same delta exposure occurs in long positions when the underlying moves around the long strike price.
The rapid increase in delta of both long and short options during expiration week creates a situation where small movements in the underlying can quickly turn a winning position into a loser. Closing your positions the week prior to expiration week will remove this exposure to rapid changes in delta and keep you on the path of high probability options trading.
