Managing Option Spreads
If you have been following my blog on options trading, today’s blog is a logical next step. Today I would to start with a framework and a way of thinking to explain how I manage my options trades.
I have some rules, but the rules are not as important as understanding of the methodology for managing the options trades and for understanding the inherent flexibility of options trading.
One of the problems for new traders is that they set up a trade and put it into place and then stop all thinking about the trade. That is incorrect. It is very important to think about the trade set up in terms of which way you think the market is going, are you bullish on this particular stock and it’s important to spend some time looking at the liquidity, volume, spread between bid and ask and of course the Bollinger Bands. We always want liquidity, so we can trade in and trade out, we want tight spreads between bid and ask, so we can maximize profits and this is also a sign of liquidity, and we want to make high probability of profit trades, such as when we are selling premium we want to place our trades somewhere out in the 80 or 90th percentile, where there’s a very low probability of the stock reaching this price. But while it’s important that you put thought into placing the trade, it’s equally important that you monitor the trade.
Options trading in general is not a set it and forget it type of activity. You monitor your trade daily and sometimes if the market is volatile, you monitor your trade a couple times a day. This is important for two reasons; first first you don’t have to wait until the Option expiration date to profit in the options trade. You are earning money as time progresses or earning a percentage of the premium as time progresses as the prices or the value of the two options diminish overtime. An option is a depreciating asset so while the premium was $100 based on the initial value of the options, as the options depreciate you have the opportunity to close the trade when the value of each component of the spread has changed to the point that the premium is now half. Remember that the whole point of the options trade is to close the trade By buying back the option you sold at a cheaper price and selling the option you purchased at a cheaper price but making enough money on the option you sell and saving enough money on the option to buy back that you’re ahead in the end. The other reason that we closely monitor the trade is that sometimes the stock price changes quickly and the options depreciate quickly So we might hit one of our goals such as a 33% premium goal or 50% premium go early in which case we will close the option treat.
This is an important concept that’s I want you to understand, so I will review it here. When I place a trade I would like my premium to be about a third of the potential loss. So numerically this means if the potential Loss is $300, I would like the premium will be at least $100. This means I am willing to risk three dollars to make one dollar. Some people set their trades up as if they are willing to risk five to dollars to make one, but in general I go with the risk three to make one rule because I know I’m going to close the trade as soon as I earn 50% of the premium.
Restated this means the premium represents X dollars and in general I am attempting to get half of X and close the trade. So if the premium is $100 what you’d like to get out of this trade is around $50. The reason for this is a little complicated, so stay with me here. Because as soon as you get $50 out of the street you’d like to close it, because once you’ve earned $50 it’s not worth the initial risk of the trade for the other $50. This is hard, so let me explain this; whenever you open an option trade you have the money that you can make it say $100 and you have the money that you could lose which is perhaps $300, so your risking 3 to make 1, with 80% odds of success. But once you are at point where you could close the trade and make $50, you are now still risking the $300 loss, but now it’s for $50 not $100, so now your risking 300/50 or risking $6 dollars to make $1 and although your odds are still 80% the return ration has dropped 50% and no longer worth the risk.
So once you’ve made $50 but your risk is still two $300, so once you get half you close the trade. The trading education group called TastTrade has studied this and shown that it’s much smarter meaning more profitable in the long term to close that trade and redeployed your money in a new trade. This is a hard concept for people to understand, so it’s OK if you have to read the section again a few times. Once you understand it then you also understand that I also close the trades if I get 33% of the premium in the first week because I can close the trade and open a new one and my risk is greatly reduced by closing the trade.
It’s important to remember that You don’t become a successful traitor by By making a lot of money on a single trade. You are successful by making multiple good trades, so as soon as the trader is good, I close it and I move on because it is the nature of the up-and-down action of the market that a trade which is up 33% this week might be down 5% next week or you might be down to being 15% ahead next week so you take your gain when you get can get it and you close to trade.
People sometimes say that this trading style leaves money on the table. That phrase suggests that I am not getting all the potential profits. But this attitude suggests that you’re forgetting that the trade is not all about profit, the trade is about profit and avoiding loss and it’s this risk of loss which drives you to close the trade. It’s really about the math not abandoning the profits. You are risking $300 to make hundred dollars but you don’t want to risk $300 to make $50 so once you have that $50 in hand you close to trade and take that sure thing because 80% odds of winning is very good but there still a 20% of loss so once you are presented with a 100% chance to get the $50 you take it. The second part of this equation is the contract multiplier. Wwhen we get 50% of our premium which may be $50 out of the hundred dollars that may be on one contract, but if we are trading 10 contracts or if we are trading 100 contracts what were actually taking off the table is $500 or $5000. When you look at this multiple where you are looking at a potential profit of $5000 and a potential loss of $15,000 once you get the $5000 you don’t want to risk the $15,000. Remember that two emotions fear and greed are our enemies and we must keep them both under control.
So to recap we manage our options trades at the outset, by setting up good trades; good volume in a stock that has good volatility with a premium which is healthy enough to risk money to get that premium, remembering that we most likely are going to close the position for half of the premium and should we see an early profit of 33% within the first week or so we’re going to close the trade and take that profit. The underlying idea here is that we open a trade knowing how much your premium is and how much money we have at risk because and once we get half of that premium we close the trade because the amount of premium that were trying to capture becomes much smaller, while the amount of risk never changes. Always remember the math and that fear and greed are our enemies.
✍🏼 by Shortsegments.