Sell To Close Options

The Smart Profits Report: Issue #288
Thursday, March 2, 2006

Sell to Close Options: How “Patient” Trading Turned $8,000 into $192,000
by Steve McDonald, Advisory Panelist, Mt. Vernon Research

The most difficult decision an investor makes is not which stock or option to buy or when to buy it. It’s when to sell to close. It is a nagging problem that has only one solution: Let your winners run and dump your losers. Oh, if it were only that easy.

In 25 years of trading, I have found that more investors struggle with the decision over when to take a profit, as opposed to when to take a loss. The most veteran traders sell once they hit their trailing stop. But no such stop exists on the upside.

That’s why it’s important to have a strategy for letting winners run and taking profits. While the following example may be unconventional, you’ll soon see what happens when you do, in fact, ride out the winners.

A “Welcome Home” 958% Gain

I recently received a phone call from an elderly business acquaintance I’ll refer to as Mrs. B. She asked me if I could help her understand an item on her brokerage statement. I told her she should call her broker, but she said he didn’t understand her question.

Mrs. B told me the item on her statement showed the following: 100 contracts of XYZXX, with a purchase price of $8,000 and a market price of $192,000.

I asked her what the question was. She said, “Is this correct?”

I said, “It sounds very high, but let me check the option symbol online.”

I looked up the symbol and multiplied the bid by 100. It did, in fact, come to about $192,000. Something else caught my attention - the option was set to expire in three days.

Mrs. B then asked me what she should do. Since I couldn’t give personal advice, I did the next best thing. I told her she should transfer the account into my name, immediately. (Only kidding.) I ran through the choices available to her and told her to contact her broker and have him advise her on the next move.

Before she got off the phone, I asked her why she held the options so long. I explained that it was very unusual for anyone to be so disciplined as to let a winner ride to within three days of expiration. Her answer is one of the best I have heard in all the years I’ve been involved in the money business.

Mrs. B said she had been in the hospital for an extended stay of about three months. She purchased the option sometime before being admitted to the hospital. About a week after returning home, she began sorting the mail. She came across the brokerage statement and was certain the $192,000 value of the account was erroneous.

It was no mistake.

Sell to Close Options…and Keep Walking

When an underlying stock price hits the strike price of an option, as it did in her case, the option price moves up dollar-for-dollar with the stock price. So, the higher the stock climbs, the higher the option goes.

Most of us are unable to watch an option go as high as Mrs. B’s. We have this itch that makes us sell, usually too early. We sell because we have seen too many winners turn into losers. Or we don’t understand what is happening. It’s very tough to let the market do its thing.

Letting a winner ride drives us crazy. How many times have you been about to sell a position, just to second-guess yourself, and then sell it anyway and regret it forever? This is where the real torture begins.

Traders Often Track Their Closed Options Positions…

Invariably, the options continue to climb. And that creates more of a problem the next time one has to make a decision to sell.

Call it human nature, but many people re-live what they believe to have been an error. That affects their decision-making the next time around. And that’s simply not the best mindset for making money.

Don’t look back. Period. Whether you lose or profit, keep walking.

Mrs. B was admittedly a bit lucky. The rest of us have to learn from our mistakes and continually sharpen our trading skills. Let your winners run, dump your losers and, probably the toughest part, never look back.

I wouldn’t recommend checking into a hospital to try and bump up your returns. Your insurance company wouldn’t understand.

Good trading,

Steve

Today’s Smart Profits Crib Sheet

When you buy a put or a call, your goal is to make money. And preferably, lots of it. But instead of buying the shares outright, you’re employing leverage by using options. For more on getting the most out of your investment dollars, check out Smart Profits #103, Understanding Options Leverage - The Power Of Leverage Is Bigger than You Think.
In options trading, it’s important to use the correct terminology. “Sell to Open” is a phrase used by brokers that represents the opening of a short position, while “Sell to Close,” means the closing of a short position. For more useful phrases and lingo, see the Smart Profits Glossary.

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