Profit and Loss Targets when Trading Options

The beginning

This detailed discussion began here, in the comments section.

Roberto is asking about profit and stop loss targets for an iron condor and also for a ‘classic’ credit spread.

Where we are now

Thanks Mark.

But I still don’t understand why you prefer to set a stop loss around $300 in a trade (10-point credit spread) where $800 can be the maximum loss.

In a classical vertical spread, $200 credit and $800 risk, we agreed that the take profit should be around $150 but we disagree about the stop loss. Can you do a statistical example of why, over the long term, using a stop loss in $300 area, its better than a stop loss in $75 area?

Thanks again

Roberto

***

Hi Roberto,

I do not set a $300 stop loss for all trades that have a maximum loss of $800. That’s not how risk management works. There are many factors to consider.

A huge part of the problem in understanding my original comments stems from the fact that you changed the conditions

I was talking about an iron condor. You switched to discussing half of the iron condor position (credit spread), believing that the situations are similar. They are very different trades, with very different factors that go into choosing the profit and loss limits.

Why is that difference so important? In your classic credit spread, one way to profit occurs when the stock moves much higher (Selling the put spread is a bullish position). When that happens, there is a very good possibility of being able to close the position and take your target profit. Thus, selling a credit spread gives you two ways to win: The passage of time and the correct market move. Those two profit possibilities play a large role in the probability of earning a profit

With the iron condor, there are no profits when the stock moves higher. It just means that the call portion is in trouble rather than the put portion. There are no profits under those circumstances. There is no possibility of taking profits quickly. This position requires the passage of time before the trade can reach its profit target. It is important that you recognize that changes the probability of success by so much, that no matter how you set the risk/reward ratio for a credit spread, it must be set very differently for the iron condor. The iron condor is where this discussion began.

I hope that’s clear to you. The credit spread wins far more often than the iron condor. If you ask: Why not trade the credit spread instead, the reply is that I don’t know whether to sell a call spread or a put spread.

Time out for an important issue

Experienced traders may recognize that there is another big factor that has been ignored: The effect of implied volatility. When trading an iron condor, a big volatility increase can result in being stopped out of the trade quickly. It is true that credit spreads are also short vega, but only half as much as an iron condor. When you establish a relatively small stop loss, you can get forced out of the trade, even when the underlying asset does not make a threatening move – just because IV rose by enough to make the position hit your stop loss target.

That factor alone – the possibility of being forced to exit by a spike in implied volatility is the major reason why I would never use a small dollar value as a stop loss point. To me it is far too risky to stop yourself out of trades that quickly. I don’t believe you can stay in those trades long enough, often enough, to claim your profit. Thus, I choose a larger stop loss and know that my edge is that I’ll be stopped less frequently than you. Is that enough to make my method better? For me, yes. For you? I cannot know that answer.

End of time out

I make trade decisions by doing what I believe gives me the best chance to make money when combining my chosen strategy with my personal risk management decisions.

You must understand that we do not disagree on anything. I believe that a stop loss at $300 is better for me than a stop loss near $75. You believe that a $75 stop loss will be effective for you. We must each trade according to our comfort zones. Neither one of us is wrong. I allow for a larger loss to reduce the possibility that a change in IV will force an early exit.

I can understand why you may believe that one of us must be correct and the other person must be making a mistake. However, neither one of us is wrong. Here’s my best explanation of why believe that no one is wrong here.”

  • If you own the position and the loss reaches $100, or $150, you may become very uncomfortable holding onto the position. You may become upset and feel ill. You may lose sleep. A trader cannot allow that to happen. Even if we are investors and not traders, it’s the same situation. It is wrong to hold positions that make us nervous because it means that too much money is at risk. It is also very unhealthy. Losing money is part of the trading game, and if it’s going to upset you – then you are correct to cut losses before you reach that point.
  • It is far better if we can do a statistical evaluation of the trading plan. However, that’s impossible
    • We have no volatility estimate for the stock in question. I assume that you recognize that a very volatile stock will lose that $75 far more often than a non-volatile stock. And it will take a longer time for the profit level to reach $150 because options of volatile stocks hold their premium longer than options of non-volatile stocks. If you get stopped often and if it more time to make the profit, how can that be a profitable plan?
    • When dealing with statistics, time remaining is a crucial factor – and the time remaining before expiration arrives is unknown in our example trade
  • The single fact that we collected $200 credit trading that ‘classic’ credit spread is not enough information to solve this problem.

Statistics

Lacking enough information to solve the problem, and ignoring trading costs, we know this much:

  • The $75 stop loss and the $150 profit target
    • You can afford to lose twice as often as you win to break even
    • Thus, the probability of the spread reaching the stop loss point must be less than two in three (win once, lose twice, zero gain)
  • The $300 stop loss and the $150 profit target
    • I must win twice as often as I lose to break even
    • Thus, the probability of the spread reaching the stop loss point must be no more than one in three (win twice, lose once, zero gain)
  • You choose $150 as the profit target and $75 as the stop loss because those numbers have proven to be effective, and you have the profits to prove it. The other choice is that you have no such evidence but believe these numbers will be effective. However, using that 2:1 ratio as a strict guideline is a huge mistake. I guarantee that. If you use a ratio, it must change when trading more volatile stocks. It must change when the strategy changes. It may have been useful when trading stocks, but it’s worthless (in my opinion) when trading options

Setting stop losses is necessary. Choosing the price at which to set them is a crucial decision, and no simple formula is going to be satisfactory.

The end

When trading an iron condor, I often give up on the trade when one of the 10-point spreads reaches a price between $500 and $550. Thus, my stop loss is not based on the number of dollars lost. Is that heresy? If I collect $300 for the position, then my stop loss is about $250 (plus the cost to cover the profitable side of the trade). If I collect only $250 in premium, then my stop loss is about $300 (plus the cost to cover the winning side).

I exit the trade when I believe risk has reached the point at which I am not willing to lose any more on that trade. It has nothing to do with my profit target. That is the reason I do not use a risk/reward ratio, and I hope this explanation makes sense. You don’t have to agree with my conclusions, but you should understand the reasoning behind them.

I never said that it is ‘better’ to set the stop loss at $300. I said that is where I am comfortable setting it.

We each have different comfort levels and must trade accordingly. When I trade an iron condor (or credit spread) I am not willing to set exit points as low as you set them. That does not make either of us ‘wrong.’

897

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6 Responses to Profit and Loss Targets when Trading Options

  1. Roberto 02/10/2011 at 9:42 AM #

    Thanks Mark
    Ok, now you clarify the point, thanks.

    However, in my opinion, when I open any trade, I’d like to set in my mind a stop loss, a take profit and a time stop, to reduce any possibility of being tempted and lose far more than I want to accept.
    I think that topics like this its the key to success.

    Thanks again
    Roberto

  2. Mark D Wolfinger 02/10/2011 at 9:45 AM #

    Yes. Set a stop loss.
    Just don’t force that loss to be half of your profit target.

    Agree, this is a key topic for traders

    Regards

  3. Rachel 02/10/2011 at 9:29 PM #

    Hi Mark,
    Thank you so much for providing this great service!

    I have a question regarding something you mentioned in the post above:

    “With the iron condor, there are no profits when the stock moves higher. It just means that the call portion is in trouble rather than the put portion. There are no profits under those circumstances. There is no possibility of taking profits quickly. This position requires the passage of time before the trade can reach its profit target.”

    The way I have been approaching my Iron Condors is this: if early on in the trade one of the spreads becomes cheap (i.e., $0.20 or $0.30) due to a market swing, I buy that spread back, leaving me with the other spread to expire worthless or become cheap if the market swings the other direction (if all goes well; otherwise, I would consider adjusting the leftover spread). Judging from reading that quote above, it sounds like this might not be a good idea… and I would like to know why. Is it better to treat the trade as one whole animal (Iron Condor) instead of the 2 parts (each spread)? If so, why? Maybe the answers to these questions might be specific for your comfort zone, but if you don’t mind, I’d like to hear the logic behind it. (If you’ve already addressed this in a previous blog or in your book, let me know–maybe I missed it.)

    Again, thank you so much!!!

    ~Rachel

    • Mark D Wolfinger 02/10/2011 at 10:03 PM #

      Rachel,

      Thanks for the kind words.

      1) I also buy back the low-priced winning side and then manage the losing side as needed. I’ve mentioned this several times, but I cannot expect you go go through 900 posts to find it!

      It is a very good idea – if you believe in actively managing risk. The best that could happen – and it happens most of the time – is that you could have earned another twenty cents. But the worst than can happen is pretty bad. In exchange for trying to make those last couple of dims, you can incur a sizable loss.

      That’s just not a good idea, in my opinion. I’ll give up those dimes to save me from the occasional nightmare.

      2) Although I don’t mention this often enough, once I own an iron condor, it is no longer an iron condor in my mind. I am now short one call spread and one put spread and manage them independently.

      3) That quote was used to compare the ‘quick profit’ possibilities between a credit spread and an iron condor.

      Regards

  4. Wayne 02/26/2011 at 2:06 AM #

    In response to point 2 above where you said when you “own an IC, it is no longer an IC in your mind”, but you would manage the call side and put side independently. What do you think of my idea:
    Yes of course, if either side is in trouble, I will manage it (by buying put or call spread). But my thinking is, can I close both sides early before there’s any hint that things will get bad. My goal is to get the margin release early, so that I can move on to open my next IC. Being able to put my next trade on early means I can open farther OTM strikes that are “safer” and can still collect a high premium due to the time value. Then in this next IC, I also close it out early and hopefully so early that I can keep going to pretty OTM strikes (that are “safer”) and that have good time value in the premium that I can collect.

    • Mark D Wolfinger 02/26/2011 at 7:46 AM #

      Wayne,

      You and I agree. I close one side when I’m ready to do so. If I can pay up a little to close BOTH sides simultaneously, I’ll do that.

      However, at all other times I look at two separate trades, each with it’s own risk. When there are no problems and positions just fade into oblivion, it does not matter how they are managed because no management is needed – except for the decision of when to exit.

      Farther OTM strikes may seem safer, but they do have longer lifetimes. If you close a 15 delta option and sell another 15 delta option, that ‘safety’ is imaginary. But I understand. It feels safer, and there is much comfort (false comfort) in that.

      Thanks for sharing