will be a loser if the underlying is below the lower of the two break-even
points—in this case $65.75. This point is found by subtracting the premium
received from the strike. Before expiration, negative gamma adversely
affects profits as the underlying falls. The lower the underlying is trading
below the strike price, the greater the drain on P&(L) due to the positive
delta of the short put.
It is the same proposition if the underlying is above $70 at expiration. But
in this case, it is the short call that would be in-the-money. The higher the
underlying price, the more the −1.00 delta adversely impacts P&(L). If at
expiration the underlying is above the higher breakeven, which in this case
is $74.25 (the strike plus the premium), the trade is a loser. The higher the
underlying, the worse off the trade. Before expiration, negative gamma
creates negative deltas as the underlying climbs above the strike, eating
away at the potential profit, which is the net premium received.
The best-case scenario is that the underlying is right at $70 at the closing
bell on expiration Friday. In this situation, neither option is ITM, meaning
that the 4.25 premium is all profit. In reaping the maximum profit, both
time and price play roles. If the position is closed before expiration, implied
volatility enters into the picture as well.
It’s important to note that just because neither option is ITM if the
underlying is right at $70 at expiration, it doesn’t mean with certainty that
neither option will be assigned. Sometimes options that are ATM or even
out-of-the-money (OTM) get assigned. This can lead to a pleasant or
unpleasant surprise the Monday morning following expiration. The risk of
not knowing whether or not you will be assigned—that is, whether or not
you have a position in the underlying security—is a risk to be avoided. It is
the goal of every trader to remove unnecessary risk from the equation.
Buying the call and the put for 0.05 or 0.10 to close the position is a small
price to pay when one considers the possibility of waking up Monday
morning to find a loss of hundreds of dollars per contract because a position
you didn’t even know you owned had moved against you. Most traders
avoid this risk, referred to as pin risk, by closing short options before
expiration.