Reducing a Winning Trade
One of the greatest problems to have while trading options is finding yourself in the position of not wanting to give too much of your profit back. In this post we're going to talk about what to do when you've got a big option trade win on your hands, a stock price that says it isn't over yet, but a nervousness that is telling you that you need to book some profit.
Managing Profits
The first thing to always remember is that your trade profit in dollar or percentage terms has absolutely nothing to do with the current suitability of the trade itself. The chart is what matters, not the fact that your trade percent says 100%, or $1,000, or whatever the case may be. Those numbers, in relation to the trade itself, are meaningless.
However, psychology undoubtedly plays a huge part in trading success. Being nervous about your trade exposure, whether with a winning or a losing trade, is something we want to avoid. That nervousness leads to bad choices, which inevitably will lead to bad returns.
So here we're going to look at three ways you can decrease your option's trade exposure, without closing the trade.
Delta
You can't make an informed trade decision (and you really shouldn't be trading options at all) if you don't understand the concept of Delta.
Delta is the ratio that compares the change in price of an option to a corresponding change in the stock.
In layman's terms, The delta is how much you will gain/lose if the stock price goes up/down $1. Let's review quickly.
In this option chain for AAPL we can see all the relevant pieces of information we need if we are long a $185 call option.
Share Price $188.02 and Delta of .60.
If the Price drops to $187.02 the value of the option will fall by .60. A $1.00 fall in the stock price means a $60 fall in the option's value. Since the price of the option is $7.10, this also equates to a 8.5% drop in the option's value.
So, let's say you are up 50% at this point, you are very happy with that, and you don't want to give that profit back. Your initial reaction is to sell. Book that profit and take the rest of the day off. Tell your spouse about the great trade you made.
But what if the stock's chart still looks great? What if the stock itself is not giving you any reason whatsoever to close the trade. Maybe the stock just broke to new highs and is still chugging away at its high of the day. Is there any reason to sell that now? Of course not. You want to maximize your profits by making calculated decisions, not because your gut is churning.
At the same time, like we said, psychology matters in trading. So what can we do?
Reduce Exposure
One of the most often overlooked strategies by new traders is one of the simplest. This goes for both option trading as well as stock trading. The strategy is to simply REDUCE your exposure.
With stocks it is straightforward since you will most likely own more than one share. All you have to do is sell the amount that would get you back to your risk comfort zone. If you own 20 shares of AAPL and you want to book some profit, but still stay long the stock, you can just sell some. Sell 5 or 10 shares and you've now booked some profit and reduced your downside exposure. Simple.
With options it can be a little trickier, especially for newer traders or traders with relatively small trading accounts. If you happen to own more than one contract, great, you can follow the same system you did with stocks. Just sell some. But if you find yourself in the position of just owning one contract you can't do that. So what can you do? There are actually quite a few things.
Roll the Option
To roll the option you are going to Sell to Close the option you currently own (the $185 call with the .60 delta), and Buy to Open a different option. In this example we'll stick with the same expiration, but you could also roll out to a different expiration.
Let's say you want to reduce your exposure by 1/2, but you only own 1 $185 call. To reduce that exposure you need to cut your delta from .60 down to .30. You can do this as a spread, or individually with two separate trades. Either way you are going to...
Sell to Close 1 x $185 call and Buy to Open 1 x $195 call
Now, instead of being long .60 delta, you are long .30 delta. If AAPL stock drops $1 you will lose $30 instead of $60. Of course, reducing your downside exposure also reduces your profit potential. If AAPL stock rises by $1 you will make $30 instead of $60.
Create a Spread
This is very similar to the Rolling strategy, but can give you more choice. With Rolling the Option you need to be careful that you don't end up buying something way out-of-the-money, like a $200 call for instance. That might give you the reduced exposure you wanted, but might not be the same sort of trade that you initially intended. In other words, you might not think the price is going to move that far that fast, in which case the out-of-the-money call might not perform well.
Turning your $185 call into a call spread is a good solution. Let's say that you are still bullish AAPL, but want to reduce your exposure just a little bit, like by 1/3 instead of the 1/2 we previously discussed.
In that case we can keep our $185 call, but Sell to Open a higher strike price call. The $200 call has a Delta of .18, which is very close to 1/3 of your current .60 delta. So, by selling the $200 call our net delta would go from .60 to .42. You could really create just about any sort of risk profile you wanted with this strategy by choosing an option whose delta matches your needs.
The nice thing about this strategy is that if you are right about AAPL continuing to climb you will continue to make money, and it's even possible that your higher strike call could lose value (this is good because you are short this call) as time passes.
Stock Hedge
There is one other solution, but it isn't one we'll go into too much detail on. If you are an advanced trader with a fairly large portfolio this one might be easiest for you, but this trader is also the least likely to need to use this solution, so we won't dwell on it.
To hedge your $185 call with stock you would sell short the number of shares you wanted to in order to lower your delta to your comfort range. In this case we are long a call with a delta of .60, so you would sell short 30 shares to reduce your exposure by half.
A trader that is long a put with a delta of .60 could BUY 30 shares of AAPL stock to reduce their exposure by half.
This is a capital intensive solution, and would rarely if ever be more useful than the option trades highlighted above.
Conclusion
There is no rule that will suit every trade with regards to when to take profit or when to reduce exposure. Every trade is different, and every trader is different. Keep in mind that we want to maximize profit as much as we can. This means not closing winning trades just because the numbers are starting to make us nervous. All this means is that the trade is doing what we expected it to do. However, it is also important to recognize when it's time to reduce exposure in order for us to remain comfortable and maintain our personal risk parameters. These strategies should help you to stay in winning option trades longer.