At what point should I close out a credit spread for a profit?
50% of the initial credit received. Based on various substantial market studies it has been found that if you close out your credit spread trade once it reaches 50% of the initial credit received (or max potential profit), you have the ultimate win rate and overall profit long-term. So, if you sell a one dollar wide credit spread for $.50 you would try to close out the trade when the value of that spread decreases down to $.25 which is half of the max potential gain. Though counterintuitive, by taking a smaller profit more often and exiting the trade faster you’ll end up with higher win rates and total dollar profits in the end.
How long do you keep a position open if it’s going favorably vs. unfavorably?
With risk defined strategies like credit spreads, iron condors, and iron butterflies we will keep the strategy open and working until it meets one of our exit targets for profit or until the last week of expiration. Because we should be appropriately sizing our positions on order entry, we need to give the probabilities enough time to work themselves out. Entering a trade with a 70% win rate does mean that it’s going to win within the first week - it might take all month to come around and be a winner. With undefined risk trades like short strangles and straddles we will be more aggressive in adjusting these positions and will look to take them off for a loss when the value of the option is 3X as large as the initial credit. For example, if we sold a strangle for a $50 credit and the value of the strangle increased to $150 we might look to close the position and take the loss trying to avoid even bigger losses. Otherwise, the trade will keep working until it meets our criteria for early exit and profit taking. You can learn more about our exit targets by downloading our “When to Exit” PDF guide inside the membership area.
I work a full-time job and can't watch the markets all day - how can you automate the process of exiting trades?
Easily with GTC order. Exiting trades, as a general rule, should be as automatic as possible. Most of your work in the analysis should go into trade entry, but trade exit should be very easy and systematic with little thought or emotion involved. We always prefer to use GTC or Good 'Till Canceled orders for all of our exiting trades that get us out at our predetermined profit targets. For example, if we sold a short strangle for $100 credit, we would automatically enter a GTC order to buy back that same short strangle at a $50 premium whenever it decays in value to that point. This is a great way to automate your entire workflow process for exiting positions while taking the emotional interference out of the trade.
On risk defined trades should I ever use a stop-loss order?
No. The best way to manage these trades is to make them small from the beginning since these types of trades are defined in risk you are much better off to let the probabilities work themselves out over many trades. We recorded a podcast (Show #14) that discusses the exact reasons why you would not want to use a stop loss orders and why these types of orders create more losses because of a strike price's probability of touch.
At what point do you look to take profits on a calendar spread?
25% gain. Because calendar spreads are low probability strategies, you will want to take profits earlier, and we like to start exiting the trade at a 25% gain from the initial debit paid to enter the position. So, if we paid $100 for the calendar spread, we would look to setup an automatic closing order to sell the calendar when the value increases to $125 per calendar.
When I close an option position is the money that I made or lost automatically credited or debited from my account balance?
Yes. If you originally had a long option position where you paid a debit to enter the position then closing a losing trade would mean selling it back to the market it’s new price. If you paid $100 for a call debit spread and you sold it for $20 in the future (resulting in an $80 loss) you would be left automatically with the different or just $20 in your account leftover. For short option positions, the process is reversed. If you sold a call credit spread for a $100 credit and later the position decreased in value to $20, and you bought it back for its value (resulting in a $80 profit) you would be left automatically with the difference or just $80 in your account as profit.
At what point should I close out an iron condor trade for profit?
50% of max potential gain. We believe the best time to close out an iron condor trade to maximize your win rate, and chance of success is to close out the trade when you have reached 50% of the credit received or max gain. This means that if you sold an iron condor for $200, you would look to close it out when you've made a $100 or when the value of the iron condor drops by 50%.
At what point should I close out a short strangle trade for a profit?
50% of max potential gain. Very similar to the iron condor trade example above, you would look to close of a short strangle trade at a 50% of the credit received or max gain. This means that if you sold a short strangle for a $150, you would look to close out of that trade at a $75 or when the value of the strangle goes down by $75.
At what point should I close out a short iron butterfly trade for a profit?
25% of max potential gain. Short iron butterfly trades are the alternative version of a straddle. Since we close out of our straddles at a 25% of credit received or max gain, you would similarly look to close out of short iron butterfly trade once the value of the overall spread goes down by 25%. This means that if you sold a short iron butterfly for $100, you would look to close out the position once it reaches $75. This does take in a smaller profit but ultimately leaves you a much higher win rate long term and a higher total dollar profit at the end of the year versus reaching for a higher profit on each trade and possibly losing more often.
Should I be using stop-loss orders on naked or undefined risk trades like strangles and straddles?
Maybe. We do believe that having very wide and high stop-loss orders can protect you from black swan type events. For this reason, we prefer to set stop-loss orders on undefined risk trades at the 3x or 4x the credit received. This means that if you sold a straddle or strangle for $100, you would close it out when the value of that option increases by 3x or 4x. Setting your stop-loss orders to anything tighter than this may increase the number of losing trades that you have because our probability of the stock touching our strike price is almost twice as much as the probability of actually losing. For more information on this subject and setting appropriate stop-loss orders, please listen to our Show #14 of the Option Alpha Podcast.
I’ve heard that stop-loss orders create more losing trades - how can this be?
Because of the difference in the probability of touch vs. the probability of expiring. Let’s take an example by looking at a stock trading at $50 per share. Looking at the probabilities right inside your broker platform you’ll see that the $45 strike puts (below the stock price) might have a 30% probability of expiring ITM at expiration which means that there is a 70% chance they expire worthless or OTM at expiration. So, if you made this trade 1,000 times and let each and ever trade go all the way to expiration, with no adjustments, theoretically you’d win approx. 70% of the time. Now, we also know that the probability of the stock “touching” or “trading down to” a particular strike price is 2x the probability of it expiration ITM. So, using the same example above the stock has a 60% probability of coming down from $50 and touching or trading at the $45 strike price between now and expiration. Remember this is 2x the probability of the $45 strike being ITM at expiration which is 30%. Now assume that you set a stop-loss order to exit the trade whenever the trade moved against you and created a loss, which is what most traders do. In this instance, you’d be almost guaranteeing that you’d lose about 60% of the time because that’s how often you’d hold a paper loss during the expiration cycle. If you had just waited, not set a stop-loss, and let the numbers work out as they should then you would have been a winner long-term. But setting a stop-loss in this instance created more losing trades.
Why is it important to close out profitable trades well before expiration if possible?
It's important to increase your win rate and reduce trade duration as an options trader. We always prefer to close out profitable trades ahead of expiration when they reach our predetermined profit targets. This increases our overall win rate and reduces the time and exposure we have in the trade. We constantly see that when most of our trades are initially entered at the 70% chance of success level, our long term win averages much higher than that because we are diligent in closing out of trades early and banking profits. This also gets us out of trades that are winners now before they might turn into losers in the future.
If a trade isn’t going the way you want would you hold it all the way until expiration?
Short answer, yes. We do not know when the trade will go our direction if it does at all during this expiration cycle. Probabilities of success do not determine when that probability of success will occur. All we know is that at the end of the month if we consistently make the same types of trades, we might have a 70-80% chance of success. That doesn't mean that we'll have that chance of success early or later in the cycle. For this reason, we always hold all of our trades until expiration, if necessary, to give the stock an opportunity to realize fully the potential exposed in the probability calculation.