Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Options Money Management – How to Take the Money and Run

|Includes: SDS, SPDR S&P 500 Trust ETF (SPY)

Traders know that identifying a stock market top is virtually impossible -- except in hindsight.

 

Many money managers recommend adding to positions that are showing a profit.   In contrast, I believe in ‘Take the Money and Run’. This second brief article will show you how to capture your profits even if the market moves in your direction and then stubbornly retraces and takes away some or all of your profits.  This article, however, illustrates the concept trading options. The previous article  traded ETFs.


 
I trade with a market timer that follows the S&P 500.   The SPX is an ETF (Exchange Traded Fund) that represents the S&P 500.   Consider the above chart of the SPX. The market is in a downtrend. The timer indicates a bearish signal on November 11th 2008. 
 
At the bottom of the chart, there is a yellow histogram that indicates the percentage points gained as the trade progresses. It shows the percentage gains of the SPX during a timer signal; the white horizontal lines are at the 5%, 10% and 15% gain levels.
 
Gains of 5% have been common over the years; 10% gains occur less frequently and are often accompanied with a pull-back; gains of 15% are rare and usually transient. This money management strategy takes advantage of the stock price excursions. 
 
THE OPTIONS MONEY MANAGEMENT STRATEGY DESCRIBED
This “Take the Money and Run” strategy is straight forward. 
We are going to buy an Out of the Money call [at least $1.00 OTM] with a minimum of 45 days to expiration.  If the OTM strike is $1 below the next strike and that strike is a multiple of 5 then take the higher strike.  Ex. If the OTM strike would have been $44 then take the $45 strike
 
        When the SPX has gained 5% sell 25% of your contracts.
        When the SPX has gained 10% sell half your remaining contracts and roll the other half to 1 strike Out of the Money.
        When the SPX has gained 15% sell half your remaining contracts.
 
Table A
ACTION
OPEN
SPX GAIN 5%
SPX GAIN 10%
SPX GAIN 15%
CLOSE
DATE
11/11/2008
11/12/2008
11/19/2008
11/20/2008
11/25/2008
SDS PRICE
94.31
104.94
112.94
127.97
94.13
MARCH 96 CALL
19.98
27.30
34.50
 
20.167
MARCH 115 CALL
 
 
27.05
37.95
17.30
 
Gains without money management
We are going to buy 16 March contracts of SDS FOR $19.98 on 11/11/2008. This costs $31,968.   If we didn’t employ any money management strategy, we would have experienced a small gain of $299.20.
 
Gains employing money management
Let’s see what happens if we employ a money management strategy.
  1. On 11/12/2008 the SPX has gained over 5%. We will sell 4 contracts at 27.30 for a gain of $2,928.00 [400 * (27.30 – 19.98)]; we still have 12 contracts.
  2. On 11/19/2008 the SPX has gained over 10%. We will sell 12 contracts at 34.50 for a gain of $17,420.00 [1200 * (34.50 – 19.98)] and buy 6 March 115 contracts at 27.05; we still have 6 contracts.
  3. On 11/20/2008 the SPX has gained over 15%. We will sell 3 contracts at 37.95 for a gain of $3,270.00 [300 * (37.95 – 27.05)]; we still have 3 contracts.
  4. On 11/25/2008 we sell to close the remaining 3 contracts. We sell 3 contracts at 17.30 for a $2,925 loss [300 * (17.30 – 27.05)].
 
Summing up the profits gained in steps 1 through 4 above, we show a total option profit of $20,697.00.    This represents a gain of 64.74%. This gain was made possible by selling contracts at prescribed levels to take advantage of the price move. 
 
This scenario is not unusual. Many times we find that the market goes in your direction. However, before we know that the direction has change, we give back some of our hard-earned profits. By capturing the money when it is available, we turn an OK trade into a great trade. 
 
It is critical for investors to take profits when they present themselves. The concept of adding to a trade as the trade progresses adds considerable risk. In addition, in these volatile markets, it is important to have a money management strategy that reduces risk rather than increasing risk.


Disclosure: No positions