Lock in the Profits

Some recent comments have focused on the decision of when to exit a successful trade – a trade with limited profit potential.

Note. This means we are not discussing a situation in which you own some calls (or puts) and the market is going your way. You either go with the trend, take some money off the table, or exit. I can offer no guidance in that type of situation. What makes that so different is that potential profits remain unlimited.

When profits are capped, things are different.I assume that almost every trader who sells a credit spread or a naked option has some price at which covering makes sense. If a trader sells a 60-day call spread, collecting $2.00 and the position can be closed one-week later by paying 10 cents, that almost all traders would happily pay that dime. Fifty-three days is a long time to hold a spread when the most that can be earned is $10.

It’s a different story when expiration is three days away and the short call is still OTM by 5% of the stock price. For the vast majority, paying even $0.05 to cover seems too high.

Do you accept those premises?

If you agree with my conclusions in the two paragraphs above, then there must be some combination of price and time that is an inflection point. Translation: There is some time element, combined with the cost of exiting, that makes the decision a toss-up.

I know that I will pay 15 cents for a 10-point spread (underlying asset = RUT, Russell 2000 Index) even when it is one week prior to expiration. And I’ll pay 10 cents after that. I seldom collect the last penny.

I also pay twenty cents to cover almost any position when it is not a front-month spread. In fact, I’d probably pay $0.25. The point is that I have a price I am willing to pay that depends on how wide the spread is (how many point separate the long and short legs), the nature of the underlying (an $800 index is not the same as a $30 stock).

I don’t believe that traders must have such pre-determined exit points. Risk management decisions are personal and individual. However, I do believe it’s a good idea and I recommend knowing where you would like to exit. Such information can be part of the original trade plan.

From my perspective, it is better to lock in the profits when there’s not much to gain by holding. To others, every penny is valuable and they cover only when they believe it’s the correct move.

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