For some traders knowing when to exit a profitable trade is a lot harder than finding a good trading candidate. After all, you're not only managing a position…you're managing emotions. Unfortunately, there are no hard rules to follow.
In most cases, it's situational.
However, I'll try to share some thoughts that could probably help.
When you're buying premium and playing for direction, you want to know how much you make on a winning trade compared to a losing trade. Some traders can actually end up being net profitable even if they only win 35-40% of their overall trades.
Well, their average winning trade is significantly larger than their average losing trade.
Furthermore, it's important to have some statistics on your trading results. If you're a new trader, you need to record your performance. I touched on this in Why Style Drifting Can Kill Your Success & Bank Roll…but would like to expand it here.
What you should record:
How many trades do you put on (daily, weekly, monthly, yearly)
How many trades are winners (gross)
How many traders are losers (gross)
What are all your fees
What are your net realized gains after fees
What are your net realized losses after fees
What is your winning percentage
What is your win/loss ratio
You see, knowing how much you win and lose on average…along with your winning percentage will give you great insight on what kind of adjustments you'll need to make to become a profitable trader.
In an earlier example I mentioned there are traders who can get away with winning less because their win size/loss size ratio is high. On the flip side, there are traders who can win 55% of their trades and still end up being net losers.
They either can't cover fees or their average losing trading is much greater than their average winning trade. For example, if your average winning trade is $1,000 but your average losing trade is $1,200…you won't make it if you win 54% of your trades.
In this case, you've got to let your winners run more…or tighten up your risk…so that losses become smaller.
With that said, it's important to recognize the type of trade you're in.
For example, if you bought NETFLIX ATM calls ahead of earnings you should be aware that volatility will get sucked out of the options… and if the stock price barely moves or sells off…those options will get killed.
This is a high risk/potentially high reward trade. Knowing this, you should prepare for the worst-what you could potentially lose if you're wrong.
I'd also put biotech stocks in the high risk/potentially high reward category.
For more information on identifying the type of trade you're in, check out: When to Stop Out of A Trade And Take A Loss.
Now, if you're using options to express a technical view on a stock. You might want to do some "what if" analysis. Most brokerage platforms have position analyzers. For example, if you use thinkorswim (like me)…you can "play" around with the analyzer….
…what will my options be worth if the stock reaches this level?
…what will my options be worth in a couple days if the stock stays flat?
…what will happen to my options if implied volatility comes in a couple points?
By doing this type of what if analysis you'll have an idea of what your options will be worth under various scenarios. In addition, you'll have insight on how long the options can be held for until the time decay starts accelerating.
The position analyzer is a great feature for those technical traders who want to know how various price levels will affect the value of an option under different volatility moves and time frames.
What If you buy options based on unusual options activity?
This one is a little trickier because you're following the smart money…but it's not your idea. Unlike trading an event or a technical pattern…you're not always sure why the smart money has gotten into the trade.
In most cases, the options market is forward looking and ahead of the news. Was This 2 Million Dollar Options Trade Ethical? is a great example of this.
Again, knowing what your average win rate, win size/loss size ratio, average winning trade and average losing trade can really help.
You'll hear many professionals tell you to trade your position and not your PnL. Of course, this is easier said than done. For example, I know some traders who will get less aggressive on a trade they like if they are getting hurt in other positions.
Or they might take profits a little early to make sure they cover their losses in another trade. Is this the right way to trade?
Probably not…but it will help you avoid large drawdowns.
One method of taking profits is to scale out of a position. For example, let's say you buy 10 call options for $1.00 apiece. The options start moving up to $1.30. The trader sells 8 calls for $1.30. The trader makes $240 in profits, they are left with 2 options that initially cost $200.
This trade guarantees a profit, with two runners. The trader could hold the rest of the call options and see where they go. This is just an example, different configurations could be used. Is this how you should trade?
Again, hard to say…what if the stock really runs…if you held all 10 of those calls…they would have given you incredible gains. Remember, options offer convex payouts…unlike stocks they don't move in a linear fashion.
For example, on Monday, July 21, 2014. Herbalife 7/25 $50 puts opened at .25 when the stock was around $60 per share…the stock fell 11% and option volatility exploded after Bill Ackman announced he would give a presentation on why the company is a fraud….those $50 puts traded as high as $2.50…if you pieced out…you could have missed out on some nice gains.
Is it smart to piece out? It could be…again, it depends on your numbers and what your losing trades look like. If you are a responsible trader with who doesn't take big losses…then piecing out or scaling out will work.
In fact, it's a technique that I use very often.
Of course, there will be times when you piece out and the stock really moves…probably wanting to kick yourself for not holding the full position. But that's trading…successful investors and traders I know and have met know that it's about longevity, not getting greedy, taking a little bit out of the market and stacking your chips.
After all, no one can really pick tops or bottoms-and that the stock market can be very random at times.
Sure, lady luck could be on your side when the stocks in your direction when your fully sized up…capturing massive gains…but when you're buying options and playing direction…when you that move…it makes sense to sell in it.
Remember, when you are buying options you're not only playing direction…but you're also long option volatility and it's a race against time.
In addition, you've got to take into account the opportunity cost. For example, money allocated in one position means less money available for another. Having some dry powder for the next opportunity is never a bad idea.
For me, the decision is an easy one…sell into strength…if I miss a bigger move with less positions on…so be it. I know my numbers and what I've got to do to be successful.
On to the next trade.
I bring this up because last month some members of the OptionSIZZLE community followed very large unusual call buyers in September $50 calls in Twitter on June 12th….The large buyers paid between .80 and .90 cents on over 60k contracts. Within three weeks, those options more than doubled…some are still holding…at the time of this writing those options are trading .47 cents.
If they pieced out, they would have taken their profits and had capital free for the next opportunity. Not saying that this trade doesn't have a chance to still work…but you've always got to look at your opportunity cost.
And for those Herbalife put buyers…if they held those options on Tuesday they would have seen the stock rise over 25% and the option volatility get crushed.
It's examples like this (which happen way too often) why I piece out of my trades.
Now, here are some advanced alternatives to taking profits. Always keep in mind that costs associated with trading…bid/ask spread and commissions.
Another way one could take profits is rolling out of your position. For example, let's say you bought 10 of the 7/25 50 puts for $1.00 and sold them for $2.00. You could take your $1000 in profits and buy another strike or contract month. This gives you chance to still gain…while only risking profits.
You might want to roll your position to reduce the size the of your premium exposure. In addition, you could do it to increase your leverage…while reducing risk. For example, let's assume the trader still felt that Herbalife had more room to go down.
They could have taken their profits and 13 bought 7/25 $44 puts for .70. In this example, they have more leverage (13 contracts) but less risk.
Is this a viable alternative? Possibly, but I wouldn't do it with this stock. Why? Because Herbalife options are tough to trade. If you don't know what I mean, just read What Are The Best Stocks To Trade Weekly Options? In it I go over my criteria on finding good options that are tradable.
If you're in a long term option trade that has profits, spreading might make sense. For example, let's say you bought ATM options that are 200 days till expiration. The calls you bought doubled from $2 to $4….however, you still like the trade but don't feel comfortable with having that much premium concentrated in the position.
You might look to sell some further out of the money options to collect a $1 premium. This reduces your overall exposure…while keeping your trade in play.
You could also do this with near term options if the implied volatility is high enough.
Another way to keep the trade alive is by hedging. For example, you bought bullish calls and still believe in the trade. You might want look at buying puts to hedge against an adverse move. Keep in mind, you may be adding to the risk. For example, if the stock trades sideways…the time decay will come out of the calls and puts.
Furthermore, it's best to do what if analysis if you want to go this route. After plotting the trade in your position/risk analyzer…you'll know if it makes sense or not.
What Should You Do?
As you can see, there are several approaches to taking profits. To be honest, we know the best answer after the fact.
"Oh If I just held those options, I'd be up X amount of dollars now"
"I should have sold here, but now it's too late"
"I sold way too early"
Again, if we knew the perfect time when to sell our winners trading would be easy. There are no hard rules. The best thing you can do is familiarize yourself with your trading performance, identify the type of trade you're in and do some what if analysis.
Piecing out, rolling, spreading and hedging are viable methods worth exploring…but the right answer/technique is always found out after the fact.
What about getting out of short premium trades?
Well, I'll be covering that next for you. What I will say is that it's a completely different approach than taking profits on long premium positions. In fact, it's a lot easier to understand in my opinion.
By the way, which of these three techniques will you start using first to take profits on winning trades?
I'll be hanging out in the comments section below.
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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.