Hi, I have a question regarding option's premium decay when selling cash-secured puts (similar to covered calls): as I understand, the option's premium decay is non-linear, so that the percentage of the option premium that is decreased by each additional day is not equal. Thus I am trying to find the point that after which the additional decay in time value generates much lower return on capital-at-risk, so that it is preferable to close the position instead of waiting until expiration.
I will use an example to better illustrate my question: if I currently sell May 2013 40 put on a stock (at-the-money option), and receives a premium of 2.6 per option, the maximum annualized return on capital-at-risk is 17.9% (considering 142 days to expiration). However, the 17.9% is only the total maximum possible return over the period, and it does not relate to differences within the period regarding the return on capital-at-risk. If the bulk of the premium decay occurs in the first 100 days, for instance, and if we break down the returns over this period, we will see that the actual return in the last 42 days is much lower than the return in the first 100 days. To illustrate, if after 100 days the option is worth only 0.3, then this amount represents the maximum profit over the remaining 42 days, and of course it translates into a much lower return on capital-at-risk than the return that was in the first 100 days. Therefore it may make sense to close the position after 100 days (in which about 88% of the original premium has decayed and the remaining return is only about 12% of the original premium) and open another position thereafter in order to have a higher level of return on capital-at-risk.
So my question is if there is any rule of thumb which dictates that after a certain decay of the option's premium has occurred (such as 70% or 80% of the original premium received) it is better with respect to the return on capital-at-risk to close the option position than to keep it until expiration and let it expire worthless?
My question relates generally to a cash-secured put strategy regarding options that expire within a few months. For simplicity let's assume that there is no change in the other parameters of the option over the period (such as stock price, implied volatility, etc.) and that trading costs are very minimal. Thanks.
I will use an example to better illustrate my question: if I currently sell May 2013 40 put on a stock (at-the-money option), and receives a premium of 2.6 per option, the maximum annualized return on capital-at-risk is 17.9% (considering 142 days to expiration). However, the 17.9% is only the total maximum possible return over the period, and it does not relate to differences within the period regarding the return on capital-at-risk. If the bulk of the premium decay occurs in the first 100 days, for instance, and if we break down the returns over this period, we will see that the actual return in the last 42 days is much lower than the return in the first 100 days. To illustrate, if after 100 days the option is worth only 0.3, then this amount represents the maximum profit over the remaining 42 days, and of course it translates into a much lower return on capital-at-risk than the return that was in the first 100 days. Therefore it may make sense to close the position after 100 days (in which about 88% of the original premium has decayed and the remaining return is only about 12% of the original premium) and open another position thereafter in order to have a higher level of return on capital-at-risk.
So my question is if there is any rule of thumb which dictates that after a certain decay of the option's premium has occurred (such as 70% or 80% of the original premium received) it is better with respect to the return on capital-at-risk to close the option position than to keep it until expiration and let it expire worthless?
My question relates generally to a cash-secured put strategy regarding options that expire within a few months. For simplicity let's assume that there is no change in the other parameters of the option over the period (such as stock price, implied volatility, etc.) and that trading costs are very minimal. Thanks.
