Trading: The Profitable Exit

At Options for Rookies we spend a good deal of time discussing risk management. Those discussions often lead to descriptions of when and why a trader may decide to exit a losing trade. [A complete exit is only one choice. Reducing size and adjusting the position are viable alternatives.]

This time let’s focus on what goes into the decision-making process when we exit a trade with limited profits – to lock in most of that potential profit.

Limited gains vs. unlimited gains

I prefer to focus on strategies with limited gains and limited losses. However, a great number of investors/traders adopt plays in which potential gains are essentially unlimited (at least in theory). Those trades involve ownership of naked long options.

When dealing with limited profits, there is no such thing as ‘letting profits run.’ When your maximum gain is $300 and you already earned $280, there is not much additional profit to collect. It becomes important to protect the $280 that currently resides in your trading account.

By necessity, when we own extra puts and/or calls, there is much more to consider when exiting any trade for the purpose of locking in profits. There is the concept of letting profits run, staying the course, or following the trend. Selling our long options represents a decision to exit when profit potential is still unlimited. True, we can hedge, allowing us to earn more when the trend continues, but the mindset for that trader is far different from one who trades strategies that only allow us to earn limited sums.

Why, when, how

NOTE: The discussion assumes that we exit when it suits us to do so. Being forced to exit under duress is a separate discussion.

When holding a limited gain position (covered call, butterfly, iron condor, calendar etc), my philosophy is to exit the trade prior to expiration. Why?

    It’s just a matter of dollars and sense. When the remaining profit becomes relatively small, the potential loss may make it unattractive to stay with the trade because the annualized return on your investment may be tiny, compared with the risk. I know that taking every possible penny out of every trade may be the long-term superior strategy, but sacrificing $15 or $20 per credit spread is a low cost insurance policy that prevents an occasional disaster.

    The question remains: Is it worth risking that rare disaster to gather those additional profits again and again? The unexpected event results in immediate pain and disturbing pangs of regret. If a trader earns an extra $30 from each of her next 100 trades ($3,000) by successfully holding to expiration, is it worth the money (and heartache) if, during that time span,

      • one trade results in a big maximum loss of $2,000 due to a market gap?
      • Another few trades threaten large losses before finally expiring worthless?
      • It is unclear how many good opportunities to open new positions were missed (because we want to keep the entire portfolio below a specified risk limit)

    To me, it is not a good tradeoff. I prefer having available trading capital and peace of mind, even if it does cost $1,000 per the sample numbers. Avoiding aggravation and an unhappy frame of mind is valuable to any trader.

When should the profitable exit be made? There are numerous possibilities (you can find some that fit snugly into your comfort zone), including

  • Exit any time that you are satisfied with current profits
  • Exit any time that the possible reward falls below a specific threshold
    • Ten or 15 cents per calendar month of remaining time
    • Ten percent of the original cash collected for a single credit spread
    • When the delta of your short option reaches a low level, perhaps two or three percent
    • When you want to exit both sides of an iron condor, it may be easier to get the cheap side first

    Warning: Be aware that making money on one portion of a trade is NOT EARNING A PROFIT. Positions that contain more than one ‘part’ are hedged trades. There is no ‘profit/loss’ per portion. There is only a profit or loss for the entire position.

    • If you earn $100 on the call portion of the covered call trade, there is no profit if you are losing $300 on the long stock portion of the trade. It may be a good idea to cover that call option and sell another, but please do not think in terms of locking in some kind of profit when the trade is losing money.
    • If you earn 90% of the premium from the put portion of an iron condor, there is no profit, unless you are earning more dollars from the call portion of the trade. Believing that exiting the put side locks in a profit is an important blind spot for many traders.

How? The simplest method is to exit. Sell what you own and buy the options sold earlier. However:

If you sold a cash-secured put option, there is going to be a price at which it is worth covering and eliminating all risk. However, you may want to exit the position for that specific expiration date and open a brand new trade with a different expiration. When these two trades are made simultaneously, we refer to that as rolling a position. I do not recommend rolling a position in this situation. I much prefer to consider this as two separate decisions. If it feels right to exit with your gains, do so. IMPORTANT: If there is a new trade that you truly want as part of your portfolio, then initiate the trade. But please do not feel trapped: There is no obligation to roll. You can simply exit and wait for another opportunity to sell a put option on this underlying.

When buying back one portion of an iron condor (because it is too cheap to continue to hold the short position, and NOT because you are locking in a profit), you may (or may not) want to roll up. That means selling another spread that is less far OTM than the one just bought. The benefits of doing so are that you move your position more towards delta neutral and you have a new hedge to offset some of the loss if the market continues to move in the other direction (i.e., higher when you rolled up puts). The risk is that you added downside risk by selling another put spread – when you no longer had any downside risk.

There is nothing esoteric about this process. However, understanding when YOU (there is no best answer that suits all traders) feel comfortable taking the profits, the true invisible benefit is that all risk has been removed for that trade. There is real value in that. You may not be able to put a price tag on that safety – but when trading, taking care of of risk is a continuous process.

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