Purchasing inexpensive options (or even purchasing at the appropriate price) is a necessary condition for profiting from options trading. Knowing when and how to record earnings is just as critical, if not more so. Extremely high volatility in option pricing offers for substantial profit possibilities, but failing to square off the advantageous option position at the correct time may result in enormous unrealized profit potential and big losses. Many options traders lose money not because their entry was improper, but because they failed to quit at the appropriate time or did not apply the proper exit strategy.
Challenges With Options Trading
Because of the four limits listed below, it is critical to be knowledgeable with and use acceptable profit-taking strategies:
- Unlike stocks, which may be held indefinitely, options have an expiration date. Trade duration is limited, and if missed, a chance may not reappear within the option’s brief existence.
- Long-term tactics like as “averaging down” (i.e., purchasing on declines repeatedly) are not appropriate for options owing to their short life.
- Margin requirements may have a significant influence on trading capital needs.
- Multiple considerations for determining option prices make it difficult to count on a good price change. For example, if the underlying stock rises positively, allowing for substantial profits on an option position, other variables like as volatility, time decay, or dividend payment may erode those profits in the near term.
This article examines a few key strategies for determining when and how to record profits in options trading.
The trailing stop method, which is also relevant to option trading, is a common profit-taking strategy in which a predetermined percentage level (say, 5%) is established for a specified objective. Assume you purchase ten option contracts at $80 each (for a total of $800), with a profit objective of $100 and a stop-loss of $70.
If the $100 objective is met, the trailing target is reduced to $95 (5% lower). If the rise continues and the price reaches $120, the new trailing stop becomes $114. If the price rises to $150, the trailing stop will be moved to $142.5. Now, if the price reverses and begins to fall from $150, the option may be sold for $142.5.
The use of a trailing stop loss enables you to benefit from ongoing protection against increased profits while also closing the transaction if the direction changes.
Traders employ it in a variety of ways, depending on their strategy and fitting.
- As the price rises, the percentage level may be adjusted (the original 5% at $100 aim can be reduced to 4% or 6% at $120, depending on the trader’s approach).
- The first stop-loss level may be set at the same 5% level (rather than a separate $70 level).
- Instead of option pricing, it may instead be based on underlying price fluctuations.
The crucial thing is that the stop loss level should not be set too low (to prevent frequent triggers) or too high (to avoid frequent triggers) (making it unachievable).
Partial Profit Booking at Targets
Experienced traders sometimes use a strategy of booking partial gains whenever a defined objective is met, such as closing out a 30% or 50% position if the first set target ($100) is met. It provides two advantages for option trading:
- Partial profit booking protects the trading capital to a large degree, limiting capital losses in the event of a quick price reversal, which is common in options trading. When the predetermined objective of $100 is attained, the trader may sell five contracts (50%) in the preceding example. It permits him to keep $500 of the original money of $800, which he used to purchase 10 contracts at $80 each.
- A rest open position enables the trader to profit from future profits. A goal hit of $120 results in a payment of $600 ($120 * 5 contracts), for a total of $1,100. Another option is to sell 50% or 60% of the remaining stock, leaving potential for more profit at the next level. If three contracts are closed for $120 ($360 receipt) and the remaining two for $150 ($300 receipt), the total selling value is $1,160 ($500 + $360 + $300).
Partial Profit Booking for Buyers
Similarly to the preceding example, traders book partial gains at regular time periods depending on the remaining time to expiration if the position is profitable. Options are deteriorating assets. Time decay value accounts for a significant component of an option premium (with intrinsic value accounting for the rest).Most experienced option purchasers keep a close watch on the decaying time value and square off positions as the option approaches expiration to minimize additional loss of time decay value while the position is profitable.
Buyers of options should be wary of time decay effects and close holdings as a stop-loss strategy if they reach the last month of expiration with no information on a significant change in values. Even if the underlying price advances significantly, time decay may destroy a significant amount of money.
Profit Booking Timing for Sellers
The time decay of options erodes their value over time, with the final month to expiration experiencing the highest rate of erosion.
Because of the high time decay value, option sellers profit from larger premiums in the start. However, it comes at the expense of option purchasers who pay a hefty premium at the outset and continue to lose money while holding the position. The profit potential for short call or short put dealers is minimal (capped to the premium received).Because margin money is at risk for option sellers, having pre-determined profit thresholds (traders’ set levels such as 30%/50%/70%) is vital for taking profits. With the escalating demands for extra margin money in the event of reversals, the restricted profit potential might swiftly transform into a limitless loss.
Profit Booking on Fundamentals
Option trading is not limited to technical indicators. Many traders also take long-term bets based on fundamental research to take advantage of minimal trading capital requirements.
Assume you have a pessimistic perspective on a stock, which leads to a long put trade with two years to expiration and the goal is met in nine months. Options traders may reassess the fundamentals, and if they remain favorable to the current position, the trade can be maintained (after discounting the time decay effect for long positions).Profits should be recorded if unfavorable circumstances (such as time decay or volatility) have a negative effect (or losses should be cut).
In the event of a loss in options trading, averaging down is one of the worst methods to use. Even though it seems to be highly tempting, it should be avoided. It is preferable to close the existing option position at a loss and begin over with a new option with a longer period to expiration. Remember that choices have expiration dates. They are useless after that date. Averaging down may be appropriate for equities that can be held indefinitely, but not for options. Instead, averaging up may be a decent technique to consider for profit-making, providing there is enough time to expiration and the position’s outlook remains positive.
For example, if the aim of $100 is met, purchase an additional five contracts in addition to the ten purchased earlier at $80. The current average price is ((10*80 + 5*100)/15 = $86.67). If the next objective of $120 is reached, purchase three further contracts, bringing the average price to $92.22 for a total of 18 contracts. If the next goal of $150 is reached, sell all 18 for a profit of (150-92.22)*18 = $1040. Other options include purchasing more (say, three more at $150) and maintaining a trailing loss (5% or $142.5).
The Bottom Line
Trading options is a high-risk endeavor. It’s no surprise that nations like China are taking their time opening up their options market. The extremely volatile options market offers great profit potential, but trying to do so without enough understanding, properly defined profit objectives, and stop-loss techniques will result in failures and losses. Traders should properly test their tactics on historical data before entering the options trading arena with real money and pre-determined stop-loss and profit-taking procedures.
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