The next time you find yourself in a winning trade and think you can squeeze a little more, consider a few strategies to reduce your risks without giving up on more.
There’s a great scene in the movie All the Money in the World when Fletcher Chase asks J. Paul Getty how much money it’d take to make him feel secure. To which Getty replies, “More.”
Not surprisingly, this is often how you’ll feel when staring at a profitable trade and wondering whether to keep your line in the water to potentially eke out some more gains or cut bait and move on. Unfortunately, gut trading isn’t typically a great strategy in the long run.
In a sense, deciding when to get into a trade is easy. Sure, there’s lots of analysis to be done to decide which trade to take, but for most traders, the desire to “make money” can be pretty compelling on its own. Yet, when it comes to deciding when to exit a winning trade, the desire to make “more money” when things are going swimmingly can be a bit too alluring and often has consequential effects.
The next time you find yourself in a winning trade and think you can squeeze a little more, consider a few strategies to hedge your profits and leave a fixed amount of money (or rocks) on the table.
Because buying options is naturally more complex than buying stock—due to price, time, and volatility—exiting trades can be equally complex if you feel there’s still room to run. Essentially, it comes down to three choices:
1 – Do nothing.
2 – Exit completely.
3 – Realize partial profits and/or modify the trade.
Using a long call position, let’s break ’em down. See figure 1 for the risk graph of a long call.
When to Do Nothing
If you buy a call with a profit target and/or time frame in mind, it might make sense to simply let your expected scenario play out until either your profit target or time frame are hit. For example, say you buy a call option expecting the underlying security to advance 10% in the next two months. One week later, the underlying is up 4% and you have a decent profit on the call option. If your goal is to maximize the profitability associated with a 10% move within two months, it may be time to steel your spine and simply let the trade ride to achieve your original goal.
When to Exit Completely
If you entered a long call based on a specific profit target or profit range for either the options position or the underlying security, and you hit either target, then it makes perfect sense to cash out and exit, sticking to the plan you already laid out. But there’s a third option.
When to Take Partial Profits and/or Modify
When your conviction is that the underlying trend is strong and may continue, taking partial profits and/or modifying your position could allow you to improve the overall reward-to-risk trade-off. More specifically, modifications are often done to lock in profit and/or mitigate risk, while retaining the opportunity for more gains.
What’s important to note is that when you modify a trade, you’re essentially putting on a new trade. Therefore, before doing so, make sure you’re doing the same due diligence on the “new” trade that you did getting into it in the first place. Are the same factors still in play? If not, you may want to think about getting out entirely and moving on to a new opportunity.
Let’s jump out of theory and into a mock trade. Suppose stock XYZ is trading at $50 per share, and you buy 10 call options on XYZ at the $50 strike for $3 (totaling $3,000 in capital).
From there, XYZ rallies to $56 per share, and in the process, the 50-strike calls climb to $7. You’re now sitting on a $4,000 profit (minus any commissions and contract fees). If you think XYZ will continue to rally strongly, you can:
1 – Do nothing, hoping the stock keeps climbing as well as your call.
2 – Cash out and sell the 10 calls, cash in on the $4,000 profit, and move on.
3 – Realize some profit and/or modify the position.
However, there are two considerations to keep in mind when deciding to modify a trade: not wanting to walk away from the stock completely and not wanting to risk giving back the entire windfall profit if the rally fizzles and XYZ reverses.
What are some possibilities?
1. Sell Half
Once an option doubles in value, you can sell half of your original position and lock in a break-even trade at worst. Let’s consider this possibility. In our example, say you:
By doing so you’ve protected your original investment and banked $500, while hanging onto five of the calls (the remaining $3,500 in profit). If the rally continues, and the calls continue to increase, so does your profit.
On the other hand, XYZ could gap down below 50 overnight and render the five remaining calls worthless. In this scenario, you still lock in a $500 profit. Gaps aside, however, much of the time you can set a stop underneath your options price (say, 50% below current price), which could still give you a nice gain overall, depending on what price you actually exit at when your stop order triggers.
2. Sell Half and Spread the Rest
Using the same trade, you think XYZ could continue to rally up to $60 per share. You could again sell half of your calls at $7, take the original risk off the table, bank the $500, and turn the remaining calls into a vertical spread by selling higher-strike calls on those that remain (see figure 2). If the 60-strike calls are going for, say, $1.50, that’s an additional $750 you can bank now (5 x $150) without adding more risk to the trade. You’ve now locked in a total profit of $1,250, even if the stock falls to zero at this point.
Now, suppose XYZ continues to rally and closes at $60 on expiration day. You end up with a net profit of $6,250 as follows:
But if XYZ closes at $50 per share at expiration, as mentioned, you still end up with a net profit of $1,250 as follows:
With XYZ shares above $60, the profit is capped at +$6,250. For each $1 increment below $60 per share to $50 per share, the profit declines by $500. With XYZ shares at $50 or below, the worst-case senario is a profit of +$1,250.
3. Roll Up (to a Higher Strike Price)
Let’s go back to something we touched on earlier. You’re sitting on a $4,000 unrealized profit. You don’t want to risk giving it all back—but you believe there’s a good chance the rally in the underlying will continue. There’s a super simple modification you can make called “rolling up.” To roll up simply means to sell calls you now hold and use some or all of the proceeds to buy lower-priced calls at a higher strike price.
The 50-strike calls you bought for $3 are now trading at $7. During this time, the underlying stock has risen from $50 to $56 per share. A simple roll up might look like:
Let’s consider the net effect of this simple adjustment:
The worst-case scenario—if XYZ stays below $55 through options expiration, you’re left with a $1,000 profit from the sale of the 50-strike calls. However, if the stock keeps rallying, you could have unlimited potential, while your original risk and a decent profit are now “off the table.”
The good news is that option traders have many possible choices. The bad news is that too many choices can lead to confusion and indecisiveness, and at times, frustration. This is why it’s critically important that you have a plan when you enter each trade regarding which criteria would trigger you to exit the trade completely and under what circumstances an adjustment to the original trade could lead to an improved reward-to-risk trade-off.