2 Misconceptions About Exiting Option Trades Early

For years now I've talked about the concept of exiting option trades early and taking money off the table as a way to both improve your win rates and increase overall profitability. Still, I'll often get emails and questions about the legitimacy of exiting trades early vs. letting profitable trades go all the way to expiration and "milking it for all its worth" as some members have put it. Honestly, I can't blame anyone for questioning it because on paper it sounds crazy. Close a trade early for half the potential profit, and you'll make more money - who would believe that right?

Once you see the results of these four backtested short strangles in TLT, a major bond ETF, I'm confident you'll quickly change your opinion and start implementing some of the automatic profit targets we suggest in your own portfolio.

Two Major Misconceptions of Closing Options Trades Early:

Taking trades off early reduces the potential profit of the positions.
When you take trades off early, you still have the same win rate over time and therefore your return is much less.

Why do we close trades early?

With early exits, the win rate is dramatically higher.
Drawdowns for closing trades early are less than if left until expiration.
Implied volatility is overstated, so you win more than the initial probability suggests.
Get into recycling capital at a faster pace, which all leads to a higher total profit.
Take off profitable trades early that could potentially turn into losses later on.
When you leave trades on longer, you expose them to more risk for loss.
The same concept holds true with short-term and long-term periods.

Four Tests With TLT (Major Bond ETF):

10-Day Expiration Level

Short strangles were entered into on average about 10 days to go until expiration.
Each short leg on the short strangle on TLT was sold at the 30 Delta.
Every time a trade was closed, entered into a new trade sequentially.
No IV filter, no exit/stop-loss filter, just entered trades consistently over time.
Tested the difference between letting the trade go all the way to expiration and taking the trade off early, once it has reached 50% of the profit target.

Example: if a short strangle is sold for $100, will take it off once it has decayed in value by $50 and there is a $50 profit -- sell for $100 and buy back for $50.

Results

Scenario A — short strangle, 10 days to expiration, 30 delta options on each side, no filter, all the way to expiration (no early exit/close).

Annual national return, on average, was 0.66%.
Max drawdown during the period was 15.51%.
Average P&L per trade was $8.94.
Strategy win rate over the entire period was 64.84%.
Average days in trade was 10, with about 90 trades tested.
Total strategy P&L was 327% over the period.

Scenario B — early exit at 50% profit target.

Annual return was 1.37%.
Maximum drawdown was 8.3%.
Average P&L per trade was $11.19.
Strategy win rate was 83.57%.
Average days in trade was 7, with 140 trades tested.
Total strategy P&L was 858%.

60 Day Expiration Level

Short strangle at the 30 delta, 60 days on average until expiration.
Tested the difference between no profit target, and taking a 75% profit target.

Results

Scenario A — trade left all the way to expiration, 60 days.

Annual return was 1.24%.
Maximum drawdown was 14.94%.
Average P&L per trade was $25.70.
Win rate was 71.15%.
Average days in trade was 60.
Overall P&L percentage was 511% during the period.

Scenario B — used an exit target of 75% profit.

Annual return was 1.81%.
Maximum drawdown was 14.25%.
Average P&L per trade was $33.32.
Win rate was 75.93%
Average days in trade 54, making about 3 extra trades on average.
Overall strategy P&L percentage at the end of the period was 679%.

Summary

When you close out trades early, you increase your potential profit.
With early exit strategies, you recycle capital at a much faster pace and cut down on some of the trades that could have been bigger losers if left until expiration.
In most cases, ROI will increase by 1-2 X across the board.