Wednesday, August 1, 2012

How to lock in profits on an options trade and stay in the position

How to lock in profits on an options trade and stay in the position

Many times you have a winning position on an option trade, and you would like to lock in some profit but stay somehow in the game because you feel there is potential for more. You know there is potential for more but you have that internal fear of losing the gains you have up until now.

So, that is the scenario: You buy a simple Call or Put option and the trade goes in your favor. How to lock in profits on your option trade and stay in the position?

Given that I have explained most examples using Call options on this blog, today I’m going to explain this technique with a Put option, but as always, keep in mind that the same principle is applied to a Call option.

Let’s say symbol XYZ is priced at $100. You believe the stock is going down and purchase a $95 strike Put at $1.00 per contract. You need the stock to go down to $94 at expiration to breakeven on this position ($95 strike price minus $1.00 cost per Put contract). Let’s say I am buying 1 contract.

BUY 1 XYZ August 95 PUT @1.00

DEBIT INVESTED $100

XYZ goes down to $97 in the next 3 days. Your put contract gained some value. However, XYZ is not below your breakeven point yet, and if it stays at this price your Put option will slowly lose its value and will be worthless by expiration date.

How to lock in part of my gain without exiting the position thus leaving potential for more?

Here’s the trick.

Sell a more Out Of The Money Put!

You can simply sell a more Out Of The Money Put!

When XYZ went down from 100 to 97 all the Puts in the options chain gained value. Let’s say the $93 Put is now priced at $1.50. Well you simply short sell as many of these contracts as $95 strike Puts you have. For example we initially bought only one of the $95 strike price Puts at $1.00, now you sell one $93 strike Puts for the current price: $1.50.

SELL 1 XYZ August 93 PUT @1.50

CREDIT RECEIVED $150

As a result, we now have the following position:

BOUGHT 1 XYZ August 95 strike PUT @1.00 (-$100)

SOLD 1 XYZ August 93 strile PUT @1.50 (+$150)

TOTAL NET CREDIT 0.50 (+$50)

That is, we have a Bear Put Spread position and $50 dollars in our favor. Money already locked in. There is no way for this position to be a loser now. We can still make $200 extra dollars if XYZ goes down enough, but at least we already have $50 dollars of guaranteed profit and we can let the position play out, or expire. You don’t care anymore, you just leave it there for as long as possible to give your self a chance that XYZ loses more value.

The Final profit picture results in a Bear Put Spread like the following:

The whole profit picture is above the zero line. Meaning, that even if the stock retraces you have at least a guaranteed profit of $50. Of course, you also capped your maximum return. Your maximum return is not going to be theoretically infinite anymore, as when you only had the 95 strike Put. Your maximum return at most, will be $250 in this case (200 due to the 2 point difference between the 93 and 95 strike prices plus the $50 credit locked in). But you have the peace of mind that the position will be a winner no matter what, (at least $50 dollars) and you can stay in the position with no danger at all, just waiting and giving it time to work in your favor with potential to make up to $250.

Of course when XYZ lost value you could have simply closed your 95 strike Put and exited the position for a profit. But here’s the thing, maybe your 95 strike Put was not giving you $250 in return at that point and you thought there was potential for that. In order for your 95 strike Put to return $250, it needed to be worth $3.50, so that after subtracting the initial $1.00 invested on it, it gave you the $250 return.

That is where you need to make your decision.

If your 95 strike Put was giving you for example a $100 return, or $125, it was worth considering legging into the vertical spread by selling the 93 strike Put, and locking part of the profit while giving yourself potential to reach $250 of total profit with the peace of mind that the trade wouldn’t be a loser. On the contrary, if your 95 strike PUT was already giving you a $250 profit or more than that, then the best option was to just exit the trade and avoid wasting time and commissions.

To Sum Up. Whenever your directional option trade goes in your favor, consider selling a more out of the money option of the same type. As long as the option you sell has more value than the capital you invested on your initial trade, you will be locking that difference in value as your locked in gain while at the same time you stay in the trade with potential to increase your profits.

The same technique could have been used with a Call option. In that case, you first buy a Call, the stock goes up, and after the move, you sell an Out of the Money call (which is now more expensive), locking part of your profits and staying in a Bull Call Spread with potential for more profits if the stock goes up and no way to lose money on the trade.

Good luck, and happy trading!

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