Commodity option contracts are decaying assets. Unlike futures contract values from which they are a derivative, option contract values are lost each day to time decay. Unless in-the-money at option expiration, the values of said contracts are zero. Therefore, it is prudent to liquidate long option positions even if the target price is not yet realized before time value diminishes the premium.
Below is a trade example detailing the execution of a commodity option spread and the subsequent liquidation before option expiration:
On October 15, 2013, the December 2013 Heating Oil futures price closed below a lower trend line. In addition to a Trend Line formation trigger, Head & Shoulders and 1-2-3 Top formations were in development. If futures were to trade through the trigger price, the low of 2.9215 (10/01/13), this would setup a short entry opportunity based on the chart formation breakouts.
Turning to the options market, as Heating Oil futures can be volatile and require a relatively higher margin requirement, a Bear Put spread position was established. A Bear Put spread involves purchasing a put option on an underlying futures contract, while simultaneously writing (selling) a put option on the same underlying futures contract with the same expiration month, at a lower strike price. This spread is best suited for a market with potential downside profit opportunity with limited risk. Recall, the two additional chart formation setups had not yet triggered. The spread though was executed on 10/16/13, with known risk, in anticipation of the breakout. The 3.0000 put option was purchased, while the 2.9800 put option was sold. The spread was executed for 85 points or $357 ($4.20 per tick). The maximum risk on the trade was the $357 premium plus commissions and fees. The maximum profit potential was $840 minus commission and fees or the premium paid.
Analyzing the December 2013 Heating Oil chart, the downside target was the low of 2.7650 (4/18/13). Soon after the execution of the spread, the futures price traded to a new recent contract low of 2.8905 (10/25/13). In the process, confirmed the additional chart formations breakout. After a retracement to 2.9860 (10/31/13), in between the spread strike prices, the market sold-off, establishing a new low at 2.8285 (11/07/13). When the spread was executed there were 40 days until option expiration. On November 11, it appeared the market bottomed out while key technical indicators were starting to turn bullish. Instead of waiting out option expiration, which was now fourteen days away, and even though the downside target was not yet triggered, it was prudent to liquidate the spread for a known profit of 175 points or $735. If both strikes remained in the money the total profit would have been $840. However, by giving up 25 points or just $105, a profit was secured while eliminating risk. Sure enough, the December 2013 Heating Oil technical indicators were correct and the futures contract rallied. By option expiration, November 25, the underlying futures market closed at 3.0321, above both strike prices. If the Bear Put spread was not liquidated it would have been worth $0.
Ideally, every option spread trade results in collecting the full profit potential. Nevertheless, you can only take what the market gives you. Had not given up $105 to make $735, the result would have been a loss of $357 plus commission and fees. While trading option contracts be prepared to adjust the trading plan to maximize profit potential. This is especially true while trading decaying assets.
