If you are in a fortunate situation where you bought out-of-the-money options and then the market moved favourably in your direction to the point where the value of the underlying is at your estimate of where it should be, what do you do with your existing option position? You would have made a small fortune and there are a few options:
1. Sell the option – you will probably pay a higher spread since it is in-the-money and will be receiving less time value;
2. Sell the common, and wait for the exercise – doing this will expose you to the downside below the strike price and also give up the time value of the option;
3. Sell the common, and exercise – doing this will give up the time value.
In most cases, the best option is #4: Sell an at-the-money option.
This maximizes the time value remaining in the option. There is still downside risk, but your in-the-money option’s time value will increase at it approaches the strike price, which acts as a weak hedge.
I generally do not play with options because they are incredibly inexpensive instruments to play with (mainly spreads, but they are also commission-heavy). The few times it makes sense is always when you are receiving good value for money – in the most recent case it was something trading at a far lower volatility than it should have combined with an obviously retail order on the ask that I just had to hit. The other instance was selling high-volatility puts in instances where things couldn’t get any lower. Sometimes those automated models do offer some free money when they do so without regard of the fundamentals of the underlying stock.