When and The right way to Take Profits on Options

Buying undervalued options (and even buying at the best price) is a crucial requirement to benefit from options trading. Equally essential—or much more essential—is to know when and how you can book the profits. Extremely high volatility observed in option prices allows for significant profit opportunities, but missing the best opportunity to square off the profitable option position can lead from high unrealized profit potential to high losses. Many options traders find yourself on the losing side not because their entry is inaccurate, but because they fail to exit at the best moment or they don’t follow the best exit strategy.

Challenges With Options Trading

Because of the next 4 constraints, it becomes essential to be acquainted with and follow suitable profit-taking strategies:

  1. Unlike stocks that will be held for an infinite period, options have an expiry. Trade duration is proscribed and once missed, a possibility may not come back again through the short lifespan of the choice.
  2. Long-term strategies like “averaging down” (i.e., repeated buying on dips) are usually not suitable for options attributable to its limited life.
  3. Margin requirements can severely impact trading capital requirements.
  4. Multiple aspects for option price determination make it difficult to bank on a positive price move. For instance, the underlying stock moves favorably to enable high profits on an option position, but other aspects, corresponding to volatility, time decay, or dividend payment, may erode those gains within the short-term.

This text discusses a couple of essential methodologies for a way and when to book profit in options trading.

Trailing Stop

A very talked-about profit-taking strategy, equally applicable to option trading, is the trailing stop strategy wherein a pre-determined percentage level (say 5%) is ready for a selected goal. For instance, assume you purchase 10 option contracts at $80 (totaling $800) with $100 as profit goal and $70 as a stop-loss.

If the goal of $100 is hit, the trailing goal becomes $95 (5% lower). Suppose the uptrend continues with the value moving to $120, the brand new trailing stop becomes $114. An additional uptrend to $150 changes the trailing stop to $142.5. Now, if the value turns around and starts happening from $150, the choice will be sold off at $142.5.

Trailing stop loss means that you can profit from continued protection against increasing gains and to shut the trade once the direction changes.

Traders use it in multiple variants, depending upon their strategy and fitment.

  • As price appreciates, the share level will be varied (initial 5% at $100 goal will be modified to 4% or 6% at $120, per the trader’s strategy).
  • The initial stop-loss level will be set at same 5% level (as an alternative of individually set $70).
  • It might even be based on underlying price movements, as an alternative of the choice prices.

The important thing point is that the stop loss level ought to be set at neither too small (to avoid frequent triggers) nor too large (making it unachievable). 

Partial Profit Booking at Targets

Experienced traders often follow a practice to book partial profits once a set goal is reached, say squaring off a 30% or 50% position if the primary set goal ($100) is reached. It offers two advantages for options trading:

  1. Partial profit booking shields the trading capital to a great extent, stopping capital losses in case of a sudden price reversal, which is continuously observed in options trading. Within the above example, the trader can sell five contracts (50%) when the set goal of $100 is reached. It allows him to retain $500 capital (out of the initial capital of $800 to purchase 10 contracts at $80).
  2. A rest open position allows the trader to reap the potential for future gains. A goal hit of $120 offers a receipt of $600 ($120 * 5 contracts), bringing a complete of $1,100. One other variant is to sell 50% or 60% of remaining, allowing room for further profit at the subsequent level. Say three contracts are closed at $120 ($360 receipt) and the remaining two are closed at $150 ($300 receipt), the entire sale value might be $1,160 ($500 + $360 + $300).

Partial Profit Booking for Buyers

Just like the above scenario, partial profits are booked by traders at regular time intervals based on the remaining time to expiry, if the position is in profit. Options are decaying assets. A good portion of an option premium consists of time decay value (with intrinsic value accounting for the remaining). Most experienced option buyers keep a detailed eye on decaying time value and commonly square off positions as an option moves towards expiry to avoid further lack of time decay value while the position is in profit. 

Buyers of an option position should concentrate on time decay effects and will close the positions as a stop-loss measure if entering the last month of expiry with no clarity on a giant change in valuations. Time decay can erode quite a lot of money, even when the underlying price moves substantially.

Profit Booking Timing for Sellers

The time decay of options naturally erodes their valuation as time passes, with the last month to expiry seeing the fastest rate of abrasion.

Option sellers profit by getting higher premiums at the beginning attributable to high time decay value. Nevertheless it comes at the price of option buyers who pay that prime premium at the beginning, which they proceed to lose through the time they hold the position. For sellers of short call or short put, the profit potential is proscribed (capped to the premium received). Having pre-determined profit levels (traders’ set level like 30%/50%/70%) is essential to take profits, as margin money is at stake for option sellers. Within the case of reversals, the limited profit potential can quickly turn into a vast loss, with the increasing requirements of additional margin money.

Profit Booking on Fundamentals

Option trading occurs not only on technical indicators. Many traders also take long-term positions based on fundamentals evaluation, in an effort to profit from a low trading capital requirement.

For instance, assume you’ve a negative outlook a couple of stock resulting in a protracted put position with two years to expiry and the goal is achieved in nine months. Options traders can assess the basics once more, and if they continue to be favorable to the prevailing position, the trade will be held onto (after discounting the time decay effect for long positions). If unfavorable aspects (corresponding to time decay or volatility) are showing adversarial impacts, the profits ought to be booked (or losses ought to be cut).

Averaging Up

Averaging down is one in every of the worst strategies to follow within the case of losses in options trading. Despite the fact that it can be quite appealing, it ought to be avoided. As a substitute, it is best to shut the present option position at a loss and begin fresh with a brand new one with an extended time to expiry. Remember, options have expiry dates. After that date, they’re worthless. Averaging down may suit stocks that will be held perpetually, but not options. As a substitute, averaging up could also be a great technique to probe for profit-making, provided there’s sufficient time to expiry and a positive outlook to the position continues.

For instance, if the goal of $100 is achieved, buy one other five contracts along with those 10 bought earlier at $80. The typical price is now ((10*80 + 5*100)/15 = $86.67). If the subsequent goal of $120 is hit, buy one other three contracts, taking the typical price to $92.22 for a complete of 18 contracts. If the subsequent goal of $150 is hit, sell all 18 with a profit of (150-92.22)*18 = $1040. Other variants include further buying (say three more at $150) and keeping a trailing loss (5% or $142.5).

The Bottom Line

Options trading is a highly volatile game. No wonder countries like China are taking their time to open up their options market. The highly volatile options market does provide an unlimited opportunity to profit, but attempting to achieve this without sufficient knowledge, clearly determined profit targets, and stop-loss methodologies will result in failures and losses. Traders should thoroughly test their strategies on historical data, and enter the choices trading world with real money with pre-decided methods on stop-losses and profit-taking.

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