I use the following spread sheet to determine when and whether to buy back a put option (please note that commissions are calculated into the costs and original premium):
The number in red is the price to buy back the option, and $857.47 is the difference between the original premium and the cost to close. The composite number in the last column is the percent gain or loss plus the percent of time remaining. When that number is at 100% the buy back is neutral. You neither win nor lose on the contract. If the number is negative, I would normally not buy back the option for I would sooner take possession of the underlying upon expiry–I should be comfortable owning the position in the underlying or I wouldn’t be selling the put option in the first place. If the final number is above 100% then buying back the put can be done without disadvantage, because the time decay and percent of gain still add up to 100% as on the day the put was sold. Here are the circumstances I use to buy to close:
(1) Buy to close a put if the composite number adds up to over about 135%. This means that the premium has plummeted because the underlying has increased rapidly in market price. At this point it becomes interesting to buy back and realize fast gains and then use the margin value to sell another put. Gains can be multiplied by doing this. So for example, I sold 2 puts on RY and bought it back 8 days later as such:
Less than four percent of the time had passedt, and yet there was 36.9% gain on the position. The composite was at a very nice 133% and I didn’t have to wait another 225 days to re-risk the capital, which I used in turn to sell a put on PWE:
The composite number was an astounding 144.5% after only 36 days. I repurchased the put. Thus, the total realized gain over $305 + 617.50 = $922.50/$9500 (captial at risk)= 9.7% gain in a period of 44 days, which represents a 80% annualized gain. This shows how it can be lucrative to buy back a put option.
(2) Buy to close a put when it only costs about $50 and there is more than about 60 days remaining. Since most of the original premiums for me are in the $700 – $1000 range, it makes sense to buy back something that has so much time left on it but costs so little to buy back–less than $1 per day. When its more than $1 per day, it’s probably better to let it expire worthless.
(3) Buy to close a put after losing confidence in the underlying. TA was downgraded at TD Waterhouse and Scotia Capital. I bought back the position as follows:
The composite number was still at an advantage to me, but I had lost confidence in the underlying and did not want to take the position if the put expired in the money. I still came out ahead on this one by $362.52.
So far these are the guidelines that I use to buy to close put options and would appreciate any pointers or questions that people might have to make in the comments.