[Options] Best Practices: Selling Half

Sean McLaughlin
June 17, 2019

One of the things I harp on here is Best Practices. When I make it a habit to engage in best practices in terms of both strategy selection and position management, I put myself in position to win more often.

Best Practices skews odds in my favor. It keeps me from swimming upstream against volatility currents. It keeps my risk lower. It helps with P/L consistency. And it helps me stick with trades that still have time to play out.

Selling Half is a position management best practice I employ most often when trading straight long calls and long puts. I like to sell half of my position when the value of the position has doubled. It can be very tempting to want to hold your entire position if it quickly runs up and you find yourself sitting on tremendous profits thanks to the leverage inherent in long options. And certainly, there are times when I wished I would've just sat on my hands as I watched a stock continue to fly higher. But for every one of those times I wish I had, there are easily five other times I'm glad I hadn't.

You see, when a position doubles or triples (or more) in size, the open profits are nice -- but they are distracting. What??? Hear me out...

We're managing a portfolio of positions. For example, at this time we currently have 24 open positions. And I do my best to attempt to normalize the risk taken in each position such that the amount of money I might lose in any one position is relatively consistent across all positions (it is more art than science with naked options and options spreads). Out of necessity, each position starts out small.

When we have the good fortune of a long call or long put position really taking off in our favor, it skews the value of the position to be much larger than other positions in the portfolio. This isn't really a bad thing and it is necessary in achieving big wins. But the effect on my psyche is that it tends to draw all my attention to it -- to the detriment of the many other positions I need to be managing as well. And as the value of this winning position swells, I'll often find myself dwelling on every move, watching every tick, and sweating every pullback. And I promise you nothing good comes from this. When I find myself in this mental rut, soon after I find myself making bad, emotional trading decisions. Fear and greed begin to dominate my motor skills. I'm no longer following a plan, instead I'm riding a wave of emotions -- poison to a rational trader.

I'd like to highlight a position I'm currently managing in Merck $MRK that is a great example of the Selling Half best practice and it's benefits in action:

On February 11 (excuse the "2/1" typo on the chart), the All Star Charts team was bullish on $MRK. I liked the play too, and I greatly liked the very low volatility being priced into options at the time (the blue line at the bottom of the chart). So we got long July 82.50 calls that had seven months until expiration -- giving us lots of time for a bullish move to play out.

Much to my satisfaction, $MRK started trading higher almost immediately and three weeks later, the calls we bought for $1.40 were then trading near $3.00. As is my Best Practice, I sold half of the calls at $2.80. But why would I take profits on this runaway freight train? Because I cannot predict the future.

On March 1, we still had nearly 5 months to go until expiration. That is a lot of time for literally anything to happen. And sure enough, we saw a wicked pullback in $MRK that saw it trade down from a high of nearly $84/share down to nearly $72/share -- briefly flirting with a rising 200-day moving average that hadn't been visited upon in several months. Had I still been sitting on my entire position, I would've been taken on quite at open equity ride -- seeing all my open profits completely evaporate, and then some! And who knows what havoc that might've played on my mental state?

Instead, thanks to my Best Practice of Selling Half at a double, I was able to rest easy knowing that the contracts I sold paid me back all of my original risk capital. Worst case scenario then (as it is now) is that the remaining calls expire worthless leaving me with net zero gain. That's a heck of a lot better than taking a loss! And because I was "playing with house money" during that epic pullback, I was able to ride it out and let the long term merits of the bullish trend we were riding play out.

Today, we're still holding our remaining long July 82.50 calls and we're in position to potentially ride this stock higher on another breakout to new all-time highs. There is still plenty of premium left in these calls, which represents pure profit to us. When we get into the month of July, we'll reassess our position. If $MRK isn't trading significantly above our 82.50 strike price then, we'll close our calls for whatever we can get and book our profit. If $MRK is trading significantly higher, then we'll treat our long calls like a long stock position and hold for as long as we can and look to exit on the break of any near-term support -- again, booking our profit.

All of this is possible because my Best Practice of Selling Half kept me in the game. Had I not, there's no telling what might've happened. Maybe I would've ended up making more money? Maybe I would've puked out at the lows for a loss. Either way, it's highly likely it would've been unsettling and distracted me from making smart decisions with the rest of my portfolio too. No bueno.

Now before all you Captain Hindsight traders jump all over me for not selling more during the early parts of that selloff, just know that I cannot predict or control the future -- and neither can you. I'd rather stick to my plan, manage my risk and position sizing, and let the chips fall where they may. This is another edge that plays out in my favor over the long run.

~ @chicagosean

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