Why You Should Buy Back Your Obligation in a Credit Spread

05/19/2010 12:01 am EST


One of the questions that often comes up in many of my option classes when teaching the credit spread strategy is what to do with the short leg. This entire article will focus on providing a clear answer to that question, while covering all other relevant details.

Now, let me start by laying down my reasoning for buying back my obligation during the expiry week for a nickel or less, always and without any exception. Rather than giving out another hypothetical example with the usual XYZ stock, I will pull out a real-life example that many of you still might recall. So, here we go with Goldman Sachs (GS) as an ideal illustration as to why an OTM put credit spread had to be unwound prior to the expiry.

As we are coming into the expiry for May 2010, many of us still clearly remember what happened to GS last month. Last April, just a day before expiry, Goldman Sachs closed on that Thursday afternoon at $184.07. I have inserted the chart below that shows how strong GS looked on that day. Observe the black diagonal line running upwards, representing the bullishness of GS.

Figure 1 - Click to Enlarge

Now let us just speculate that there were option traders who felt bullish on GS earlier on in April when a number of green candles in a row appeared. Due to their technical analysis, they placed a bull put (also known as a short vertical put, or a credit spread) that involved the strike prices of 175/170. More specifically, their bull put spreads involved these contracts: A short OTM (out of the money) April (2010) 175 put and a long (even deeper OTM) April (2010) 170 put. The aggregate of these two legs produced a credit, which isn't part of the discussion of this newsletter. On that Thursday afternoon, the April 175 put was worth a penny due to the fact that the GS price was all the way up at the 184-ish zone, which is almost ten points away from the sold 175 strike price.

Let us play out two scenarios, the first one with the well-seasoned option trader who places, after the entry into the position, an order to buy back his obligation (the short leg; in our case, the April 175 put), and the second one with the money-oriented (read “cheap”) option trader who waits for both of the legs to expire worthless.

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Scenario One: The Well-Seasoned Option Trader

He or she opens the 175/170 bull put spread for a credit, and after being filled, places another order to either buy back the whole spread for less, or just buy back the sold April 175 put for a nickel with a GTC (“good 'til cancelled”) order. The reason why I am saying that he or she could have done either of these two scenarios depends on the original plan that was placed prior to the entry. Personally, I am an option speculator, but I will not speculate on this particular example. I just want to make a point that some spread traders place the position on for a credit and then enter an order to buy it back for about one-third of the credit that they have received. The other spread traders do not close both legs. Instead of closing both long and short legs, they simply place the order to buy back their short leg for a nickel, also with a GTC (good 'til cancelled) order. Just in case some readers are confused as to why a nickel is brought into the conversation, here is the answer: Not all brokers are considered equal, meaning that there are some brokers out there who are more progressive than others.

Without mentioning any names, I will say that there are a very few who do know that holding onto a credit spread until expiry is tying up too much capital in buying power effect/maintenance. They would rather have us buy back our short obligation and lift off the maintenance than have the money tied up until expiry. In order to encourage traders to trade more, they do not even charge the commission for buying back the short leg if it is trading at a nickel or less. I do know that this sounds too good to be true, and I do confess that I did not trust them to deliver on their promise of no commission until I experienced it. Anyhow, when the price declines on the short leg to a nickel, the order is taken off the broker's server and sent to the exchanges for the fill. While the other long leg, which was even deeper OTM (April 170 put), expires worthless. The reason why the long leg did not have to be closed is because of the simple reason that the long options give us a right, but not an obligation, whereas the short option equals an obligation, period. Hence, in our case, the trader is out of his or her short put while holding onto the long April 170 put.

Scenario Two: The Money-Oriented Option Trader

In this second scenario, the trader chooses to squeeze every single penny out of the trade so he or she waits until expiry. After all on that Thursday, GS was flying high and it was most unlikely that anything could go wrong, right? The April 175 put was worth only a penny. Below are the two charts. The first one (Figure 2) is of GS, which shows the drop. The second one (Figure 3) is the chart of that actual April 175 put contract. Observe what happened to the option premium of that specific contract—no words are needed.

Figure 2 - Click to Enlarge

Figure 3 - Click to Enlarge

In conclusion, in this article, we have explained why an option trader should not be "cheap." Please do not hold onto your short options until the last day. Buy back your obligation early on and sleep well!

By Josip Causic, instructor, OnlineTradingAcademy.com

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