Moving Toward the Exits


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Once successful options traders find an underlying and a trade that meets their criteria, they need to decide where they want to exit the trade. How much profit do they expect on the trade? Where do they set the exit point for a trade that’s not doing well?

There are many approaches for establishing these exit points, but for the case of simplification, this post will only look at one technique that can be applied easily when trading vertical spreads.

Exit for profit. Determine how much of the max profit you expect to make on the trade. Traders may use a percentage of max profit at or over 50%. My preference is to initially set the profit level at 80% of max. So if the max gain is $0.50 per share, I’ll submit a limit order to close the trade at $0.10. I’ll monitor the trade closely, and if it pops in the first few days, I’ll consider closing it at a lower percentage. My reasons for doing so are two-fold. First, I view the max risk for the trade as having increased by the unrealized gain. Say our imaginary trade has a max loss of $150 against the max profit of $50. If we experience an unrealized gain of $25, we’re now actually risking $175 on the trade. Our return on risk (ROR) now has declined from 33% (50/150) to 14% (25/175). Second, consider the return on the trade in respect to how long the trade has been open. Suppose, our trade has been in force for three days and can now be closed with a profit of $25 (33%). If we calculate a 3-day return of 33% projected to a year, we get an annualized return on risk of over 3300%. Such capital efficiency is strong rationale for closing the trade. Keep in mind that this discussion is simplified, and further thought about it will reveal additional nuances worth consideration. For example, if the trade consists of multiple contracts, you might considering scaling out of it–closing on some of the contracts to preserve profit and leaving other contracts open. You’ll also want to be aware of corporate actions or other factors that can affect your trade. For example, you may want to close the trade early to avoid the uncertainties associated with an upcoming earnings report, or an upcoming vote on legislation that might affect the underlying’s price.

Exit to minimize loss. A vertical spread has a built in maximum loss, but successful option traders will be unwilling to experience it. A simple approach to establish our loss-limiting exit is to close the trade if the underlying price passes through the break-even point of the trade. Keep in mind that when we selected our trade, we determined areas of support and resistance and bought into an assumption that the underlying would be constrained by those levels. If it breaks through those levels, our assumptions are no longer valid. If we continue the trade, we’ve abandoned the rational our trade was based on. Instead, we’re now relying on hope that things will turn around. In life, sometimes hope is all we have, but its weak support for continuing a trade that’s soured. Setting the loss exit at break-even is a good place to start, but when the underlying price gets on the wrong side of the short leg on our vertical, our trade needs more attention. Do the math on what happens if the short leg is assigned; that is, if an option buyer of the contract that we have sold exercises, what impact will that have on our bottom line? Be very, very worried if the trade is approaching expiration and the short leg is ITM or close to it. Keep in mind that the long leg of the spread has been our insurance against assignment. it alone defines the max risk we’ve assumed in the trade. When that contract expires the risk becomes undefined. Let’s look at what can happen after expiration on an imaginary trade. Suppose our trade consists of a single short put at $90 and a single long protective put at $88. Let’s further assume that our max risk on the spread is $150 and our max profit is $50. Our spread expires with the underlying at $89.75. We now are on the hook to buy the the underlying at $90. We need to cough up $9000 to meet our obligation. Prior to the reopening of the market, the underlying continues to lose value, and it opens on the next trading day at $78. We are now sitting with a hundred shares of the underlying worth $7800, and our portfolio has lost $1200, a lot more than the $150 max loss expected when the spread opened. Don’t put yourself in this position.

Key take-away: Manage exits to minimize risk and maximize gain and capital efficiency.

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