On May 19, we discussed whether Target might finally be making a bearish-to-bullish reversal ahead of earnings. As the next quarterly earnings release approaches, many of the points we made then remain true now, so I encourage a review of that prior article, but because we provided a trade example then, it makes sense to review: how it performed some trade maintenance “best practices” what to do now If you do not review the prior article, this was the trade structure we laid out three months ago: Buy 1 Sept 19 110 call ($5.73 premium) Sell 1 June 27 115 call ($1.51 premium) Sell 1 June 27 84 put ($1.49 premium) That entire structure required an outlay of ~$2.73 in premium. While Target shares have risen about 4.5% since then, the following chart illustrates how the options trade performed. One notices that the calendar spread, which was long the Sep 110 calls and short a nearer-dated June 27 expiration strangle, saw its value increase within the first couple of weeks. The structure appreciated to more than $4 by June 10, when the short strangle still had 16 days to expiration. At that point, the stock had only appreciated by just over 2.8% from around $98 to $100.77. In fact, if we examine the prices of the individual options in the structure, we would realize that all of the returns generated by the options trade came from the decay of the short strangle. The short strangle was worth $3.04 as of the first closing day of the trade and was worth only 47 cents by June 10. It had lost about 85% of its value. Readers who put that trade on likely recognized that most of the potential money in the short strangle had already been made, and possibly rolled the short position further out. Consider that the most a trader could expect to make over the 16 days remaining in the short strangle was just 47 cents, or less than half of 1% of the stock price. As it happens, the strangle did indeed expire worthless, and the only remaining component of the trade, the long September calls are still worth more than the initial structure cost making the trade profitable even if one did nothing. However, one would have done far better by actively managing the trade by rolling the short options, to a longer-dated 16 delta (sometimes abbreviated 16^) strangle such as the July 25 expiration 90/115. That trade had roughly 45 days to expiration and would have collected about $2.43, net of the 47 cents one would have to pay to cover the prior short strangle that would have brought in $1.98 in additional premium. And guess what? Within the next 18 days, the new short July 25 90/115 strangle would be worth only 46 cents, also having decayed by more than 80% of the value when the trade was initiated, at which point a trader could have rolled the short strangle yet again. Using the same guidelines, targeting roughly six-to-seven weeks until expiration and 16^ calls and puts, one would have sold the Aug. 22 90/120 strangle (the 85s delta was approximately 13.5 at the time and the 90s was about 19.5. Considering the underlying thesis was modestly bullish, and generally favoring deltas between 16 and 20, without other strikes available — the 90s would be the most obvious choice). This trade would have collected $3.62 in premium on the new short strangle, net of buying back the old one for 46 cents, the trader would have collected $3.16. As of this week, that new short strangle would, once again, have lost most of its value, which would soon promote yet another roll. The chart below illustrates the difference in the P & L of buying the spread with a “set and forget,” versus managing the trade by rolling the short strangles once they have lost more than 80% of their value. The initial trade would have made about $100 per spread through Friday. An actively rolled spread would instead have made nearly $500 per spread. That’s not a little bit better, it’s a lot better. So what are the takeaways? Options premium decay (aka “theta”) can be a powerful source of returns over time. Short options positions need to be managed even if they are winning . It’s not enough to know that a short option has a high probability of profit, but that the returns it offers remain compelling. Even simple “rule of thumb” approaches can make a big difference. In this example, I simply suggest that if you sell a 16 delta (16^) strangle, you roll it once it has decayed by 80%, identifying a new short option of ~16^ with 6-7 weeks until expiration to replace it. (Important note: Keep an eye on catalysts.) Multiple factors may impact when an option should be rolled that cannot be known ex ante. We do not know exactly what a stock will do or when it will do it. We do not know precisely how implied volatility will change from day to day, although we do know that it tends to rise going into catalysts and tends to fall sharply after they have passed. So, sticking with Target as the underlying stock, what would the trade look like today? Buy the November 110 calls pay $6.15 Sell the Sept. 26 weekly 120 calls at $1.32 Sell the Sept. 26 weekly 90 puts at $1.38 If the short strangle loses 80% or more of its value, roll the options out to expirations of six weeks or so, selecting strikes of 16-20^. A trader can adjust the tenor or moneyness as they see fit, provided they are receiving a reasonable rate of return in options decay. For me, the rule of thumb is 12% annualized, or 1% a month or more, particularly if the underlying stock is highly volatile, is in a volatile industry, or has a lot of debt. DISCLOSURES: None. All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
