The Case for Letting Profits Run

As any option trader knows, there's nothing more maddening than seeing healthy profits melt away and being forced to decide whether to take smaller profits or let the position run.  Let's look at three key factors that discuss why we prefer to not take smaller profits when buying option premium.

Let Profits Run

When buying options, the most you can lose is 100 percent.  Thus, this is the smallest gain that you should target, as your reward should outweigh your risk.  Given that trading discipline usually allows you to cut losses short, 100-percent target profits on each trade is sufficient when trading most short-term options. 

On our website (www.schaeffersresearch.com/option/money_management.asp), we show that success is achievable in short-term option buying with a winning percentage between 35 and 45 percent.  The key to this success is to ensure that the average win significantly exceeds the average loss.  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 smaller profits of, say, 25 percent. 

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.  Profits must be allowed to run to the extent that they create a positive expectancy given that losers will most always outnumber winners.  Consciously taking small profits will increase the winning trade percentage slightly but will have a devastatingly negative impact on the average win.  And this stacks the deck against you in terms of achieving profitability over the longer term. 

The Delta Factor

Delta is defined as the percentage of the price movement in the underlying stock that is translated into the price of an option.  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 have the best chances of achieving "big hit" profits in part because the delta of the position has moved higher from when the trade was initiated.  This means the option will be more responsive to the stock's movement, making it easier to achieve the target profit.

For example, you buy an at-the-money 40-strike call for 2.40.  The stock rallies to 42.75 and the option now sits at 3.60 - a 50-percent profit - while the delta increases from 55 to 75 percent.  To achieve a 100-percent return, the option price must hit 4.80, which requires an additional stock move of 1.60 (or 3.7 percent) based on the option's current delta of 75 percent (1.20/0.75). 

Alternatively, you could close this position at a 50-percent profit and buy another option.  Assume this new position is similar to the original option - an at-the-money call on a $40 stock with a premium of 2.40 and delta near 55 percent.  To achieve a 50-percent profit (adding to the 50 percent already taken), the option would have to gain 1.20.  Based on a delta of 55 percent, this requires a stock move of about 2.18 (1.20/0.55), or 5.4 percent from the original stock price of 40.

Thus, to achieve the same 100-percent profit, a larger percentage stock move (5.4 percent) is required when closing out a profitable position and purchasing a new option compared to holding the original position (3.7 percent).  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 - the commissions to add a full round trip for the added position - are not trivial, especially when buying options.  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.  By selling a small-profit position at the lower bid and buying a 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. 

A Final Word

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.