Purchasing undervalued options (or even at the right price) is an important requirement to profit from options trading. Equally important-and even more important-is knowing when and how to record profits. The extremely high volatility observed in option prices provides a large number of profit opportunities, but if you miss the right opportunity to close a profitable option position, it may lead to unrealized high potential profits and possibly high losses. Many option traders ultimately fail not because they entered the market incorrectly, but because they failed to exit at the right time or did not follow the correct exit strategy.
Challenges of options trading
Due to the following four limitations, it is important to be familiar with and follow appropriate profit-taking strategies:
- Unlike stocks that can be held indefinitely, options have an expiration date. The trading period is limited. Once missed, the opportunity may not reappear in the short life cycle of the option.
- Long-term strategies such as “average down” (that is, buying on dips) are not suitable for options because of their limited lifespan.
- Margin requirements will seriously affect transaction capital requirements.
- The multiple factors that determine option prices make it difficult to rely on favorable price changes. For example, the underlying stock moves favorably to achieve high profits in the option position, but other factors, such as volatility, time decay or dividend payments, may erode these gains in the short term.
This article discusses some important methods on how and when to book profits in options trading.
A very popular profit-taking strategy, also suitable for option trading, is a trailing stop loss strategy, in which a predetermined percentage level (for example, 5%) is set for a specific target. For example, suppose you buy 10 options contracts at a price of 80 US dollars (800 US dollars in total), with 100 US dollars as a profit target and 70 US dollars as a stop loss.
If the goal of $100 is reached, the trailing goal becomes $95 (lower 5%). Assuming that the price continues to rise to $120, the new trailing stop loss will become $114. A further rise to US$150 changes the trailing stop loss to US$142.5. Now, if the price rebounds and starts to fall from $150, the option can be sold for $142.5.
Trailing stop loss allows you to benefit from continuous protection, prevent gains from increasing, and close trades when the direction changes.
Traders use it in multiple variants according to their strategies and equipment.
- As the price rises, the percentage level can change (according to the trader’s strategy, the initial 5% when the target price is $100 can be changed to 4% or 6% when the target price is $120).
- The initial stop loss level can be set at the same 5% level (instead of setting the $70 separately).
- It can also be based on changes in the underlying price instead of the option price.
The key is that the stop loss level cannot be too small (to avoid frequent triggers) nor too large (to make it impossible to achieve).
Target partial profit booking
Experienced traders usually follow a practice of pre-determining part of the profit once the set goal is reached, for example, if the first set goal (100 USD) is reached, then 30% or 50% of the position is closed. It provides two benefits for option trading:
- Part of the profit is recorded to a large extent to protect the trading funds and prevent capital losses in the case of sudden price reversals that often occur in option transactions. In the above example, when the set goal of 100 USD is reached, the trader can sell five contracts (50%). It allows him to retain 500 USD of capital (purchase 10 contracts at 80 USD from the initial capital of 800 USD).
- Resting open positions allows traders the potential for future gains. Reaching the goal of US$120 will provide a receipt of US$600 (US$120*5 contracts) for a total of US$1,100. Another variant is to sell the remaining 50% or 60% to make room for further profit at the next level. Assuming three contracts are settled at 120 USD (360 USD receipt) and the remaining two contracts are settled at 150 USD (300 USD receipt), the total sales will be 1,160 USD (500 USD + 360 USD + 300 USD).
Buyer’s partial profit booking
Similar to the above situation, if the position is profitable, the trader will regularly record part of the profit based on the remaining expiration time. Options are rotten assets. A large part of the option premium consists of the time decay value (the rest is the intrinsic value). Most experienced option buyers pay close attention to the time value of the decay, and regularly close the position when the option is nearing expiration to avoid further loss of the time decay value when the position is profitable.
Buyers of option positions should be aware of the time decay effect, and should close the position as a stop loss measure if the valuation does not change significantly after entering the last month of expiration. Even if the underlying price fluctuates sharply, time decay will erode a lot of funds.
Seller’s profit booking time
Over time, the time decay of options will naturally erode their valuations, with the fastest eroding in the last month.
Due to the high time decay value, option sellers benefit from a higher premium at the beginning. But this is at the cost of the high premium paid by option buyers at the beginning, and they continue to lose money while holding positions. For sellers of short-selling call options or short-selling put options, the profit potential is limited (capped at the premium received). The predetermined profit level (the level set by the trader, such as 30%/50%/70%) is important for profit because the margin is at stake for the option seller. In the case of a reversal, as the requirements for additional margin continue to increase, the limited potential profits will soon become unlimited losses.
Fundamental profit booking
Option trading does not only occur on technical indicators. Many traders also establish long-term positions based on fundamental analysis in order to benefit from lower trading capital requirements.
For example, suppose you have a negative outlook on a stock, leading to a long bearish position with a two-year maturity and achieving your goal within nine months. Option traders can reassess the fundamentals, and if they are still favorable to existing positions, they can continue trading (after deducting the time decay effect of long positions). If unfavorable factors (such as time decay or volatility) show adverse effects, they should be included in profit (or loss reduction).
In the case of loss in options trading, the average drop is one of the worst strategies. Although it may be attractive, it should be avoided. Instead, it is best to close the current option position at a loss and start a new position from a new position with a longer expiration time. Remember, options have an expiry date. After that date, they are worthless. The average drop may be suitable for stocks that can be held forever, but not for options. On the contrary, if there is enough expiration time and the position outlook continues to be optimistic, the average rise may be a good strategy to explore profitability.
For example, if the goal of 100 USD is reached, in addition to the 10 contracts previously purchased at 80 USD, another 5 contracts are purchased. The current average price is ((10*80 + 5*100)/15 = $86.67). If the next goal of $120 is reached, three more contracts are purchased, raising the average price to $92.22, for a total of 18 contracts. If the next goal of 150 USD is reached, all 18 will be sold with a profit of (150-92.22)*18 = 1040 USD. Other variants include further buying (such as buying three more at 150 USD) and keeping track of losses (5% or 142.5 USD).
Option trading is a highly volatile game. No wonder countries like China are taking time to open up their options markets. The highly volatile options market does provide huge profit opportunities, but trying to do so without sufficient knowledge, clearly defined profit targets and stop loss methods will result in failure and loss. Traders should thoroughly test their strategies based on historical data, and enter the world of options trading with real currency with predetermined stop loss and profit methods.