Options – Locking in Potential Profit

January 13, 2010

Every now and then, an option is purchased and shortly after that, a large move in favor of the option occurs. Depending on your market sentiment, it may be best to simply sell the option before time erosion affects its value. Another approach is to sell another option that is at a higher strike price. In this scenario, it is possible to reduce the negative time erosion factor of owning an option outright.

For example, suppose that, with S&P Futures trading at 1150.00, an at-the-money 1150 S&P call option was purchased for 20 points. Now assume the market rallies sharply to 1180 the next day. It is very likely that one could sell an 1180 (now at the money) option for approximately 20 points – this would essentially pay for the cost of the original purchase.

Now the trader is in a good position. Any close over 1150 would likely ensure profit, as the opportunity to pay for the original option presented itself. Note that profit is limited to the difference in strike prices. Many would view this not as a negative, but would be happy knowing that a “free” trade may have been placed. Profit happens on settlement higher than the lower strike price, and if the call options expire worthless, then not to worry – the trade was free.

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