Contrary to some popular beliefs, options trading should not be viewed as “set-it-and-forget-it” trades.
Yes, you can define your risk and sleep comfortably at night when you’ve sized your positions in such a way that even if the worst case scenario befell all of your positions simultaneously, you know what that total loss would amount to and you’re comfortable with it…
But true options pros are proactive with winning trades, taking profits along the way or closing winning trades when reward-to-risk begins to shift against them. And we can often “repair” trades that aren’t going our way, or at least minimize any further damage while still giving us a chance to come out ahead.
All Star Options give you the trade ideas and things to be aware of once in a trade, but it’s on you to stay on top of them to make sure you’re doing everything you can to maximize your winning percentage.
Here are some rules of thumb that have served me well over the years:
When trading credit spreads (short verticals, Iron Condors, naked puts), I’ve found it to be a best practice to close the trade when you can buy it back for 50% of the credit you took in. For example, if you collected $3.00 on a 50/60 call spread at trade initiation, you’d best be served covering this trade at $1.50 and moving on. Otherwise, you’re risking $8.50 or more to make an additional $1.50 or less. Yes, the odds may be good that the spread continues decaying towards zero, but I just don’t like risking so much for so little. It only takes a few of these to reverse on you (and they will occasionally) for you to believe the wisdom in this approach.
Conversely, when trading debit spreads where risk is capped (such as a long vertical spread), I will often begin looking to close the trade when I can capture more than half of the potential gain in the trade. Using the other side of the example above, if I was long the 50/60 call spread and paid $3.00 to enter, that means the most I could make is $7.00. When the spread trades for greater than $6.50 (yielding a greater than $3.50 profit to me), that’s when I starting looking to close.
In most cases, I will not hold an options trade all the way to expiration — especially short options. It’s simply not worth the risk to try squeezing out that extra nickel of profits. My capital can be more effectively redeployed elsewhere.
When building a portfolio of positions, I attempt to have a variety of spreads and trades open with different risk exposures. It’s always good to have a mix of long & short volatility plays, long & short theta plays, as well as long & short delta plays. There is no “ideal” mix, and we can only take what opportunities the markets give us, but when considering between two new trades to add, choose the one that will help diversify your portfolio greeks better.
If you’re an institutional player or another type of Wall Street professional, I assume you’ve got a handle on sizing risk properly. And you’ll often have mandates from above as far as what type of allocation you can have into each opportunity, as well as greater flexibility in margin and buying power.
For retail traders, I would advise against risking more than 2% of your capital on any debit spread or straight options buy — ideally less. And for credit spreads, I would limit the size of the trade such that the margin required to hold the trade is no more than 2% of your capital, as this margin represents your maximum loss. If entering a trade with naked short puts, size that position such that if you were to get assigned long stock at your short put price, the cash cost of those puts is no more than 10% of the value of your portfolio. The ultimate goal for your portfolio should be to have a wide variety of small bets to better diversify your risks, rather than a small handful of concentrated bets.
This is a working document and will be added to as we move forward. Check back occasionally.