Stock Trading

Managing Options Profits

A common problem new options traders have—and a great problem to have—is how best to take profits. Option's leverage can mean that a relatively small stock price move can mean significant percentage gains for traders.

One big mistake that new traders have is taking profit too early. Time and time again I see traders take a 30% option profit, only to watch the trade continue their way and quickly turn into what would have been 100 or 200%. Not only is this frustrating, it's also expensive. It's important to remember that most traders who have been successful over the long-term do so by collecting a couple of big winners during the year, while managing the rest for small winners and losers. Giving up on a very big winner too early can sabotage a year's worth of trading.

Avoiding that is what this post is about. How can we manage our trades effectively to both manage our risk, and maximize our profits?

Don't Trade, Manage Stops

The first thing you should do to manage a winner is... nothing. Well, not nothing, exactly, but don't sell. If the stock's chart still looks good, you want to let it ride until the chart tells you otherwise. I've got some general rules for initially managing winners.

  1. When a profit reaches 20%, move the stop up to break-even. This helps you to avoid letting a nice winner turn into a loser, while still giving the trade room to move.
  2. When it reaches 30% profit, move the stop up to 10%, and at 40%, move the stop to 20%.
  3. At 50%, move stop for half the position to 35%, and half to 20%.
  4. Continue moving stops like this as the trade climbs.

You'll never sell the tip-top tick doing this, but this strategy will keep you in many winning trades that you might otherwise have bailed out on at the first sign of a downtick, which turns out to be nothing.

Selling a Portion

Once an option trade gets up to 40 or 50% profit, traders always seem to get itchy to sell. Much of trading is psychological, and while the chart might not be telling us it's time to close the trade, getting a small profit in the books can make it easier for a trader to allow the rest of the options time to work.

I suggest closing 1/4 - 1/3 of your position, max, at this point. This gets some cash in the account, but leaves a sizable portion of the trade working. If the chart isn't telling you anything is wrong, don't try and pick a top. Let it work.

After booking some profit, settle in with moving stop prices similar to the steps listed above.

Worth remembering is that you'd like to use obvious stop levels from the stock's chart instead of random numbers based on the option's price. This isn't always possible, as there is not always going to be a strong support level to base a stop off of, but whenever possible, try and use those.

Converting to a Spread

A problem that many traders run into is that they might only have a position size of one option contract. Taking partial profits doesn't appear to be a possibility. I think this is a big reason new traders book profits too early.

But there is a way to manage a one contract option position while still remaining long, and you do this by selling a further out of the money strike priced option.

By doing this you are turning your naked option position into a spread. This does two good things. It lowers your overall delta, and effectively books a bit of profit by decreasing the amount you would "give back" if the stock were to pull back to your stock's stop price. It also decreases your time decay (theta) risk. While it limits your overall upside potential, it does allow you more room to profit than if you had simply closed the trade.

Recap

Remember, let your winners run. Options can very quickly give you a large percentage return, and that 20%, or 30%, can seem like a lot, but if the chart is still headed your way, that 20% can turn into 100% even quicker. So, while it's important to get profits booked, you don't want to be overeager.

The best advice is to step back and take a deep breath. Ask yourself, "Am I selling this because the trade has run its course, or am I selling because of my own fear of giving back my paper profits?" If the trade hasn't run its course, either stay in, or manage the position by moving stops or selling a small portion.

You want to stay in your winning trades as long as you can. By following these steps you'll have a better chance of doing so.

The Wanderer Life

Sedona

While July isn't typically a great time to visit Arizona, it's not a bad place at all so long as you head up a bit in elevation. My mom lives in the desert, but for this visit we decided a rental home in Sedona would make a better place for the family to gather. At 4400' in elevation the temps are considerably more bearable than they are in Tucson.

Being back on Pacific time takes some adjusting, but for early birds like myself, trading on this clock is great. The market is closed at 1:00, meaning in general you can wrap things up by noon and have the rest of the day wide open for things like hiking. We clambered up Cathedral Rock for this view.