Working with options takes trading to a whole new level of skill. Stocks, although challenging in their own way, are somewhat safer in the sense that you can buy them and hold them indefinitely.
With options, you’re working against the clock. That being said, you can always close an options trade prematurely (unless you’re dealing with European type options). The key to successful options trading is in knowing when to close a trade.
The Problem with Options - Volatility
Options trading can be incredibly profitable in the short term. However, this chance to make a quick buck comes at a price. You should know that options are extremely volatile, which makes them a rather sharp double-edged sword. But wait, it’s not all that grim. Options trades, at least the American versions, can be closed before their expiry date.
That leaves you, the trader, with enough maneuvering space to make a profit if the market proves to be favorable. There are several ways you can close an options trade prematurely and make a profit. The one that many traders use is partial profit booking.
Partial Profits Booking
Closing option trades prematurely is all about limiting exposure when market trends are swinging your way. Partial profit booking is arguably the most common method of doing this in any kind of trading, including those that involve options in the market. The idea is quite simple — you set different profit targets within a specific range and then close a percentage of your options when said targets are reached.
Here’s a simple example of how this works:
- You’ve just bought 10 contracts at $100 and your first target at $120, and the second one at $150
- Once your options reach $120 per contract, you decide to close anywhere from 40% to 50% of your position, thus greatly reducing your exposure while still reserving profits
- The remaining 50% to 60% of your position remains active and is waiting for that $150 profit target.
Partial profit booking allows you to preserve a good portion of your capital and reduce your risk by half. If you set your targets right, you can close an options trade while being well into the green.
Trailing Stop Loss Strategy
Trailing stop strategy is one of the more popular means of reducing risk when trading options. The way the trailing stop strategy works is by setting a stop loss that is a percentage of a target, for each of the set targets. Here’s an example:
- You buy 100 contracts at $100 and set your target profit target at $120. The default stop loss is at a comfortable $80 at this point.
- Once you hit the $120, you push the stop loss to the target price - 10% of the target. So in our case, you would end up with a trailing stop loss set at $108
You can keep bumping the trailing stop loss as you hit further profit targets, thus limiting your exposure and making sure that you’re almost always in the green.
Understanding Time Decay
Time decay is arguably the reason why many option traders close at break-even or close at a loss. This is a function of options that many don’t account for when they first start trading. Calculating time decay is essential as it will tell you how much the value of an option will decrease by the time it expires. This piece of information is important as it’s a key variable in calculating when to exit an options trade so that you sell to close for a profit.
Selling to Close for a Profit
Selling to close for a profit happens when you recognize that the price of the underlying asset is rising at a pace and value that effectively nullifies the negative effect of time decay. Your job is to do the math and base your risk assessment on the results you get.
If you consider that time decay isn’t linear and that it starts slow in the beginning only to speed up near the end, it becomes clear that anticipating a good point to close an option in the money.
Dealing with Market Volatility
Knowing when to close an options trade is tricky on a good day. Being extremely volatile, options require you to know what’s going on with the market, what’s the current shape of the entire economy, as well the underlying stock that your options are based upon.
Options premiums are a decent indicator, but they’re telling a small part of the overall story. At the end of the day, making the right decision comes down to your gut call. Having the necessary knowledge to perform the proper market analysis is an essential foundation of any decision in trading, including this one.