Buying undervalued options (or even buying at the right price) is an important requirement to profit from options trading. Equally important—or even more important—is to know when and how to book the profits. Extremely high volatility observed in option prices allows for significant profit opportunities, but missing the right opportunity to square off the profitable option position can lead to high unrealized profit potential or high losses. Many options traders end up on the losing side not because their entry is incorrect, but because they fail to exit at the right moment or they do not follow the right exit strategy.
Challenges With Options Trading
Due to the following four constraints, it becomes important to be familiar with and followsuitable profit-taking strategies:
- Unlike stocks that can be held for an infinite period, options have an expiry. Trade duration is limited and once missed, an opportunity may not come back again during the short lifespan of the option.
- Long-term strategies like “averaging down” (i.e., repeated buying on dips) are not suitable for options due to its limited life.
- Margin requirements can severely impact trading capital requirements.
- Multiple factors for option price determination make it difficult to bank on a favorable price move. For example, the underlying stock moves favorably to enable high profits on an option position, but other factors, such as volatility, time decay, or dividend payment, may erode those gains in the short-term.
This article discusses a few important methodologies for how and when to book profit in options trading.
Trailing Stop
A very popular profit-taking strategy, equally applicable to option trading, is the trailing stop strategy wherein a pre-determined percentage level (say 5%) is set for a specific target. For example, assume you buy 10 option contracts at $80 (totaling $800) with $100 as profit target and $70 as a stop-loss.
If the target of $100 is hit, the trailing target becomes $95 (5% lower). Suppose the uptrend continues with the price moving to $120, the new trailing stop becomes $114. A further uptrend to $150 changes the trailing stop to $142.5. Now, if the price turns around and starts going down from $150, the option can be sold off if the stock price falls to $142.5.
Traders use it in multiple variants, depending upon their strategy and fitment.
- As price appreciates, the percentage level can be varied (initial 5% at $100 target can be changed to 4% or 6% at $120, per the trader's strategy).
- The initial stop-loss level can be set at same 5% level (instead of separately set $70).
- It can also be based on underlying price movements, instead of the option prices.
The key point is that the stop loss level should 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 target is reached, saysquaring off a 30% or 50% position if the first set target ($100) is reached. It offers two benefits for options trading:
- Partial profit booking shields the trading capital to a good extent, preventing capital losses in case of a sudden price reversal, which is frequently observed in options trading. In the above example, the trader can sell five contracts (50%) when the set target of $100 is reached. It allows him to retain $500 capital (out of the initial capital of $800 to buy 10 contracts at $80).
- A rest open position allows the trader to reap the potential for future gains. A target hit of $120 offers a receipt of $600 ($120 * 5 contracts), bringing a total of $1,100. Another variant is to sell 50% or 60% of remaining, allowing room for further profit at the next level. Say three contracts are closed at $120 ($360 receipt) and the remaining two are closed at $150 ($300 receipt), the total sale value will be $1,160 ($500 + $360 + $300).
Partial Profit Booking for Buyers
Similar to 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 significant portion of an option premium consists of time decay value (with intrinsic value accounting for the rest). Most experienced option buyers keep a close eye on decaying time value and regularly square off positions as an option moves towards expiry to avoid further loss of time decay value while the position is in profit.
Buyers of an option position should be aware of time decay effects and should close the positions as a stop-loss measure if entering the last month of expiry with no clarity on a big change in valuations. Time decay can erode a lot of money, even if 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 erosion.
Option sellers benefit by getting higher premiums at the start due to high time decay value. But it comes at the cost of option buyers who pay that high premium at the start, which they continue to lose during the time they hold the position. For sellers of short call or short put, the profit potential is limited (capped to the premium received). Having pre-determined profit levels (traders’ set level like 30%/50%/70%) is important to take profits, as margin money is at stake for option sellers. In the case of reversals, the limited profit potential can quickly turn into an unlimited 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 analysis, in order to benefit from a low trading capital requirement.
For example, assume you have a negative outlook about a stock leading to a long put position with two years to expiry and the target is achieved in nine months. Options traders can assess the fundamentals once again, and if they remain favorable to the existing position, the trade can be held onto (after discounting the time decay effect for long positions). If unfavorable factors (such as time decay or volatility) are showing adverse impacts, the profits should be booked (or losses should be cut).
Averaging Up
Averaging down is one of the worst strategies to follow in the case of losses in options trading. Even though it may be very appealing, it should be avoided. Instead, it is better to close the current option position at a loss and start fresh with a new one with a longer time to expiry. Remember, options have expiry dates. After that date, they are worthless. Averaging down may suit stocks that can be held forever, but not options. Instead, averaging up may be a good strategy to explore for profit-making, provided there is sufficient time to expiry and a favorable outlook to the position continues.
For example, if the target of $100 is achieved, buy another five contracts in addition to those 10 bought earlier at $80. The average price is now ((10*80 + 5*100)/15 = $86.67). If the next target of $120 is hit, buy another three contracts, taking the average price to $92.22 for a total of 18 contracts. If the next target 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 enormous opportunity to profit, but attempting to do so without sufficient knowledge, clearly determined profit targets, and stop-loss methodologies will lead to failures and losses. Traders should thoroughly test their strategies on historical data, and enter the options trading world with real money with pre-decided methods on stop-losses and profit-taking.
