The Case for Letting Profits Run

Subscribers to our recommendation services often ask why we generally won’t take small profits on an option position. In some cases, we’ll forego a small gain on a position that had previously attained larger profits. For example, assume a position with a target of 100 percent runs quickly up to a 75-percent gain and then regresses to a 25-percent profit. Why not take the 25 percent and at least get something out of the trade? Or perhaps a position sits at a profit of around 50 percent for a week or so before being whittled away. Why did we let the profit disappear by not taking the 50-percent gain off the table when we had the chance?

These are excellent questions that cut to the heart of our trading philosophy and highlight one of the guiding principles of sound money management in options trading. There’s nothing more maddening to an options trader than seeing healthy profits melt away and being forced to decide whether to take smaller profits or let the position run. Because of the frequency of this question from our subscribers and the importance of this issue, we consider the topic worthy of this special report.

We will touch on three main areas that discuss why we prefer to not take smaller profits on positions that have come off larger gains. The first deals with one of the primary tenets of money management – letting profits run. The second introduces the concept of delta in options trading and why holding a position with a higher delta is advantageous. The final point deals with the basic costs of options trading. Keep in mind that we are referring to buying option premium in this report.

Let Profits Run

When buying options, the most you can lose is 100 percent. While this seems obvious, the flip side is that you can gain far more than 100 percent on your wins. Since 100 percent is what you have at risk, this is the smallest gain that you should target, as your reward should outweigh your risk. Given that trading discipline allows you to cut losses short more often than not, 100-percent target profits on each and every trade would be sufficient to profit when trading most short-term options. The exception to this rule is when trading short-term out-of-the-money options (such as with our Players series), where 100-percent losses occur more often. Target profits for such trades must be stretched higher, e.g., 200 percent.

In "Money Management Guidelines: Crucial in Determining Ultimate Profitability", we show that success is achievable in short-term option buying with a winning percentage between 35 and 40 percent. The key to this success is to ensure that the average win significantly exceeds the average loss, which must be kept in check. In order to overcome inevitable losses in the 30- to 50-percent range, a trader needs a sufficient number of 100-percent (or better) profits to boost his average win. This goal is seriously compromised by an approach of regularly locking in small profits of, say, 25 percent. There may be occasions where the market forces us to take such small profits, but we will only do so with reluctance and when we feel our choices are severely limited.

The key to this concept is the principle of positive expectancy - over a large number of trades, you should expect to achieve a positive return for each dollar you risk. For example, in the long run, an even bet on "heads" in the flip of a true coin yields a "zero" expectancy. This is based on two key facts - the probability of profit is 50 percent and the payoff for "heads" is equal to the loss when "tails" occurs. The formula for this zero expectancy is:

0.50*1 + 0.50*(-1) = 0

A positive expectancy for this bet would occur if the coin were not "true," but instead the probability of "heads" was, say, 60 percent. In this case, the positive expectancy would be 20 cents for each dollar bet:

0.60*1 + 0.40*(-1) = 0.20

Another way to achieve a positive expectancy is for the payoff for a win to exceed the penalty for a loss. If you were paid $1.20 for each head that occurs when a true coin is flipped but you lost only $1.00 when it comes up "tails," your positive expectancy would be 10 cents for each dollar bet as follows:

0.50*1.20 + 0.50*(-1) = 0.10

If your overall winning percentage is 40 percent, it is apparent that your average win must exceed your average loss in order to achieve positive expectancy. If the payoff on winning trades averages 80 percent, while the loss on losing trades averages 35 percent, this yields a positive expectancy of 11 cents for each dollar invested as calculated below:

0.40*0.80 + 0.60*(-0.35) = 0.11

The bottom line with buying options is that profits must be allowed to run to the extent that they create a positive expectancy given that the number of losers will most always be greater than the number of winners. Consciously taking small profits will increase the winning trade percentage slightly but will have a devastatingly negative impact on the average win. This stacks the deck against you in terms of achieving profitability over the longer term using a short-term option buying strategy.

Another factor regarding smaller versus larger profits is that a position will not move in your direction minute-by-minute, day-by-day, or even week-by-week in some cases. Furthermore, when you are in a position where the delta (discussed below) of the option is high and you paid a relatively small price, the percentage return on the option can fluctuate wildly. For example, if an option for which you paid $5.00 has a 75-percent delta, a one-point move in the underlying stock might represent just two percent for the stock but could affect the option by 15 percent. Successful options traders will ride these fluctuations out, as exaggerated swings in the percent return on the option come with the random noise of the market.

We conclude this section with a couple of quotes from William F. Eng’s seminal work on trading, Trading Rules: Strategies for Success:

• Profits ... must be treated with a long-term view. If a trade works out to your favor, you must allow it to stay on the books and continue making money for you.

• There is only one way to manage a trade: If it shows a profit, let it run; if it shows a loss, find an exit point to limit the losses … a trader might sell out at a small profit, having sold the high, only to find out later that the market continued to move in the direction of this trade. The trader could have made a larger profit had he not used entry techniques to exit the trade.

Our approach to managing open positions that are profitable reflects Eng’s mentality. We are adamant about achieving the targeted profit, even if it occasionally means allowing a profit to become a loss.

The Delta Factor

Delta is defined as the percentage of the price movement in the underlying stock that will be translated into price movement in a particular option contract. For example, a delta of 50 percent indicates that the option will move up (down) by one half point for each one-point rise (decline) in the underlying stock. Call options have positive delta; put options have negative delta. Delta increases as the stock price rises and decreases as the stock price declines.

Successful traders know that current profitable positions are the ones that have the best chances of achieving the "big hit" profits, assuming there is sufficient time until expiration. They know that the delta of the position has moved higher from what it was when the trade was initiated. This means the option will be more responsive to the underlying stock’s movement, making it easier to achieve its target.

Let’s look at a simple example that illustrates the impact delta has on the future profit potential of holding a slightly profitable option position versus locking out that small profit and opening a new position. We bought an at-the-money 40-strike call option for 2.40. The stock rallied to 42.75 after a couple of weeks and the option now sits at 3.60, a 50-percent profit. The call option’s delta, meanwhile, also increased from 55 percent to 75 percent.

At this point, we have two primary choices. The first is to hold on to this option. In order to achieve our target profit of 100 percent, the option would have to rise in price from 3.60 to 4.80. Simplistically speaking, this option move of 1.20 requires a stock move of 1.60, based on the option’s current delta of 75 percent (1.20 divided by 0.75). This stock move of 1.60 represents 3.7 percent of the current stock price of 42.75.

The second choice is to close out this position at a 50-percent profit and open a new option position. Assuming this new position is similar in makeup to the original call option, the new option will be an at-the-money call on a $40 stock, with a premium of 2.40 and an initial delta near 55 percent. Thus, in order for this new option to achieve a 50-percent profit (adding to the 50 percent already taken off the table), the option would have to increase in price by 1.20. Based on a delta of 55 percent, this option gain requires a stock move of about 2.18 (1.20 divided by 0.55). This requires the stock to gain 5.4 percent from the original stock price of 40.

Thus, in the example set above, a larger percentage stock move is required to achieve a total profit of 100 percent by closing out a profitable position to purchase a new option (5.4 percent) than by holding the original position (3.7 percent). This example illustrates the concept of positive convexity as it pertains to options. In other words, each incremental stock move in favor of the option buyer is increasingly beneficial because of the change in delta. Taking smaller profits to open a new position removes this benefit.

Extra Costs

An important consideration when switching positions is the transaction costs to exit and enter trades. These costs are not trivial, especially when buying options. Commissions are a factor, considering that you are adding the costs of a full round trip for the added position. This is especially important when trading fewer contracts.

The other cost is slippage – the difference between the bid and ask price – which can become significant for lower-priced options. Given that you will sell your small-profit position at the lower bid and buy your new position at the higher ask, you are incurring an added expense that you can avoid by holding your initial position. Again, this is more critical for lower-priced (and lower-delta) options, whose bid-ask spreads represent a larger percentage of the option’s premium.

Taken together, these are not inconsequential costs and they represent another barrier to switching out of low-profit trades by putting even greater pressure on your being "right" on the new trade.

A Final Word

Will this approach result in some profitable trades turning into small losers? Absolutely. But of overriding importance is the fact that this approach will allow winning trades the opportunity to achieve target profits, resulting in the necessary higher "big-hit" rate and the necessary higher average win, which will give a trader the necessary edge to be profitable over time. This trade-off is what separates the winning trader from those that eventually sink.

Should you never take a profit before it reaches its objective? Absolutely not. There might be a situation a few days before expiration where the option is very close to achieving your profit objective. Just prior to expiration, an event - perhaps an earnings release - is scheduled. If you feel the potential reward is insignificant compared to the risk ahead of the report, taking an 80- to 90-percent profit might be the prudent thing to do. For example, we recently closed a trade at an 85-percent profit the day before Election Day because of the uncertainty surrounding elections, the Fed was due to potentially announce a rate cut in two days, and we were seeing high premiums ahead of earnings that were due in two days. In our view, the risks of keeping the trade open in light of these numerous events outweighed the extra few percentage points we could have gained before hitting the target profit.

But if you remain confident in your original forecast for the stock in terms of the direction, magnitude, and speed of movement, then taking a small profit just for the sake of ringing up a "winning" trade (perhaps after consecutive losing trades) or avoiding a loss is not in your best interest in the long run.

Option buying requires an aggressive mindset, which is how we manage our trades. We play to win by going for the big hit, rather than playing not to lose by taking the small profit. The former gives us a better chance to achieve positive expectancy. The latter might help stroke one’s ego, but lowers the probability of success over time.