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Ask Trader Guy: What to Do with Worthless Short Options

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March 1, 2013
worthless short options

Q: Hey, Trader Guy! If I'm short an out-of-the-money option with expiration coming up, and it's really cheap, should I just let it expire worthless, or spend the commissions and premium to buy it back?

A: I know exactly how you feel because I short options as part of my trading strategy, too. It seems like there's a very low probability that the stock or index will move enough in one or two days to threaten the short option, but expiration week can be full of surprises. Think of it this way—if you're short an option that's nearly worthless, you've probably captured a majority of the potential premium already. In this scenario, buying back the short option does three things: takes profit, reduces risk, frees up trading capital. The downside is that you may have to pay the ask price to buy it back, and you have to pay commission on the trade.

Q: Hey, Trader Guy! If one standard deviation covers 68% of the potential changes in a stock price, is the option that has a 68% probability of expiring worthless at a strike that's one standard deviation away?

A: Not quite. The stock is going to be somewhere between $0 and infinity 100% of the time, and one standard deviation up and down from the current price theoretically covers 68% of the possible price changes. That leaves 32% of the price changes outside that one standard-deviation range. If those 32 % of price changes are equally distributed above and below the one-standard deviation levels, that means 16% are below minus one standard deviation from the current price, and 16% are above plus one standard deviation from the current price. That means you'd look for an option with an 84 % probability of expiring worthless (100% -16%) to find the strike that's theoretically one standard deviation away from the current price.

Q: Hey, Trader Guy! My wife and I trade across from each other at our desks. I forgot our anniversary or something, and I heard her mutter my name and “leptokurtic” when she was on the phone with her sister. Should I be offended?

A: Well, as we all know, context is everything. Let's try to keep this civil and assume your better half was talking to her sister about trading. “Leptokurtic” refers to a probability distribution where the peak in the middle is higher than a normal distribution. Some traders think stocks, and stock indices, exhibit this behavior. Of course, she might have been talking about your head, but you are the one that forgot the anniversary.

Q: Hey, Trader Guy! I think there's a setting on the trading platform to make all the green numbers turn red and vice versa. I'm getting whacked on some contrarian trades, and I could use some price reversals. How do I do that?

A: 3-D glasses and a barf bag.

NC
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