There are quite a few option strategies have defined maximum rewards that are approached as a result of the passage of time, changes in implied volatility (IV), and/or movement or lack of movement in price of the stock. Examples of such strategies include the sale of naked options and vertical spreads.
As the positions “mature” by virtue of various combinations of changes or lack of change in these three main forces, the initial risk:reward calculation often changes and sometimes even dramatically. The successful trader with a proper options education is aware of these changes, because the risk to gain the last bit of potential profit is often dramatically out of whack to the magnitude of the profit he or she seeks to obtain.
Let us consider the hypothetical example of a trader who has elected to open a position as a naked put seller. This trader has chosen to sell out-of-the-money (OTM) puts, the June $385 strike, on AAPL which currently trades at $440 in this example. His risk in the trade is that he is obligated to buy AAPL at the strike price at any time between opening the trade and June expiration. For taking the risk of writing these puts, his account receives a credit of $1.10 and margin is encumbered based on SEC rules. The credit received when the trade is opened is the maximum amount of money that can or will be received as a result of the trade.
As June expiration approaches, the stock remains at the $440 level and the market price of the puts he has sold decreases as a result of time (theta) decay. As the price of the puts decreases and the profits increase, the risk:reward increases. As the price declines below the often used 20% re-evaluation benchmark of the initial credit received, the risk incurred to gain the remaining residual premium is potentially substantial and may no longer be appropriate given the reward.
The experienced options trader will many times take profits and find opportunities to invest his or her money in other trades that appear to be much more attractive from a risk/reward standpoint than to remain in the existing position.
Senior Options Instructor