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Option Profit-Taking
The Smart Profits Report: Issue #295
Tuesday, March 28, 2006
Option Profit-Taking: Making It Easy ToTake the Money and RunBy Steve McDonald
Advisory Panelist, Mt. Vernon Research
Option profit-taking, or selling options for a profit, is one of the most challenging aspects of options trading. Sadly, most of us are not very good at it. No trader alive is unscathed by hanging on to a paper profit, only to watch the price drop into the red loss zone.
Let’s face it. Most people are conditioned to take losses. When a loss becomes unbearable, we sell. A profit is a different ballgame. We play, “how high can it go” gamesmanship, losing our sense of proportion, even sanity.
The fact is, there aren’t any well-marked signs that tell us when we’ve made enough money on an investment. There are feelings and hunches that tell us to hold on and to sell, sometimes within the span of a few seconds. We vacillate, from hold to sell, and watch profits drain away. But here’s what you can do about it…
How To Define A Reasonable Profit In Options
The most experienced options traders are more apt to sell than the novices when they score a profit in options. They know that you are more likely to get singed by hanging around than if you hit your mental gain and sell. They also know that in options trading, like stock trading, there are other days and other options. In other words, they won’t allow their entire financial plan to rest on one trade.
Having said that, there are no fixed rules. I don’t have a magic formula. But I’ve got guidelines. And you should, too. If I’m holding an option that suddenly moves up 20% to 40%, I’m out. By sudden, I mean one to four weeks.
Here’s another way of looking at it. If you could average 20% to 40% on all your investments in one year’s time, you’d be performing better than billionaire investor Warren Buffett. So, why wouldn’t you sell an option that ran up that much in just weeks?
Could they go higher? Sure. Can they drop like lead weights? Unfortunately, that is the more likely scenario. I have watched a lot of money vanish while I waited for an option to move just a few dollars higher.
If you stay at this game long enough, you develop a sense of when to get out. You pay a heck of a price to get to that point, but you either adapt or get eaten alive.
Don’t Vaporize A Winning Trade: Take Your Profits!
If just learning to take the money and run wasn’t hard enough, there is another process associated with selling at a profit that haunts us. It’s the tendency to look back instead of forward. Instead of deleting from our files the trade that just scored a nice profit, we keep the option on our electronic portfolio page. Now that we’ve sold it, we’re hoping the thing tanks. Why we do that is anybody’s guess. And it would seem a harmless exercise. But it’s not. Here’s why.
The simple fact that we’ve watched a trade go up in value after we sold it will convince many of us to take corrective action the next time.
On the next trade that’s made 15% to 20% or more, we’ll be tempted to hang on just a little. A few more days, we’ll reason, could produce bigger bounty.
And then what happens? You guessed it. Your healthy profit has dropped to just 5%. Then what do you do? Mind you, I’m not suggesting that 15% or 20% is the magic number. Sometimes 7% or 30% will seem like the right choice. The point is to be a disciplined trader and have the ability to walk away.
There are enough challenges in trying to make money in the markets without second-guessing ourselves and creating problems where they don’t exist. So, keep it simple when your options are profiting - take the money and run.
Good Trading,
Steve
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Today’s Smart Profits Cribsheet
- Speaking of discipline, please see Smart Profits #279, The Options Bid: The Bid, the Bid, Always the Bid, on watching the options bid prices and strategic decision-making, like using limit orders, that can increase your returns.
- What’s a European Option? Options that can only be exercised at maturity, unlike American options, which can be bought and sold at any time before the expiration date. See the free Smart Profits Glossary for more useful terms.
Related Articles:
- Position Sizing Safeguards: Prevent Corporate Lies From “Cooking” Your Portfolio
- Option Prices: How to Get the Best Price on Your Options
- Limit Order Diligence - How to Limit Your “Excitement” for Winning Trades
