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When to Get Out of an Option Trade

Updated on May 25, 2013

Gamma Risk

Whether you sell naked puts, spreads, or covered calls you will eventually come to a place where you have to make a decision of when to get out.

Right now as I write this Hub I have two Bear Call Spreads. This is an option spread where I have sold an out of the money Call and purchased a further out of the money Call. I placed this trade because I believed the stock would remain the same or drop in price. The goal of this trade is for both options to expire worthless. Because the option I sold was closer to the actual trading price the premium I collected was more than the premium I paid on the further out of the money call. The difference between the two premiums is my potential profit.

Both of these spreads have worked out nicely and the spreads are now trading for around ten cents. In other words I have made the majority of my potential profit. Both securities are trading $10-$15 from my short strike price and I have a little over a week before the options totally expire worthless.

From a technical standpoint it does not look like the stocks will reach my short strike price and I will realize the full profit of this trade. However, short term options have high gamma. In other words, if the stock does make a sudden move up these options would climb in price very quickly. I can easily turn a ten cent option into a buck or two giving back all of my gains.

The obvious benefits of staying in the trade is to collect the extra ten cents ($10.00 per spread) and avoid paying the commission of getting out. However, what most inexperienced option traders don't realize is the power of gamma.

The truth of the matter is this, "You haven't secured profits until you secure profits." A safe and profitable strategy is to get out when you have received a good portion of your profits. Good portion is defined by the trader, but 70-80% is a good rule. You may be asking yourself why I didn't get out when I achieved the 70-80% profit. The reason is that these particular stocks dropped relatively fast and my profits were made very quickly.

Because my long option is basically worthless and the commission I will pay is based on the number of options I close my strategy is to only close the short side of the trade. This is where my profit was obtained and where my risk still exists. By keeping my long option open I have the potential (although unlikely) to make a profit should the stock made a sudden surge upward. In this case I will be able to take advantage of gamma.

The bottom line is that you have to take profits in order to be profitable and you have to reduce your risk. The margin on this spread is $500 per spread therefore when I take the profits on my short position the $500 being held in my margin account will become available to me. This frees up money to make another trade. To me that is worth the commission that I will pay.

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