Which is Worse, Exiting a Trade Too Soon or Too Late?

POP QUIZ: WHAT'S WORSE, EXITING A TRADE TOO SOON OR TOO LATE?
It's a familiar scene: you plan a profit target on a long call trade, say 50%. The target hits, but something keeps you from selling. The next morning you wake up to find the market has reversed and those profits you had in your grasp vanished overnight. You vow, "Never again!" and the next time a trade hits your profit target, you dutifully exit. It is, of course, at this very point that the underlying skyrockets without you, and you're counting every dollar you left on the table as the stock ticks upward. Damned if you do. Damned if you don't.

THE PROBLEM
If you've traded options long enough, you know that the one luxury you don't have as an option buyer is time. Combined with the fear of either losing profits or missing out on greater ones, the threat of rapid time decay often triggers emotional decision making that can render even the most seasoned vet with the overwhelming desire to kick himself. Let's look at the following all-too-familiar scenario and work through a couple of exit strategies that will not only keep you in the game, but with a lot less to lose: Suppose XYZ was trading at $40 when you bought ten of the 40-strike call options at $2. Your profit target is 50%. With XYZ now at $42, those calls are fetching $3. Your target is hit and you're sitting on a 50% gain. What do you do? Take the money and run, or roll the dice? The answer: BOTH.

THE SOLUTION
At the point in which you're thinking that you ought to exit the trade, but your alter ego is telling you to stay in, try one of these two strategies out:

Simply sell enough contracts to take off the original risk, lock in some gains, but also leave some on the table. This way, you're only playing with profits. But, please, don't confuse this with a "risk-free" trade. As long as money is involved, there is no such thing!

For our hypothetical trade, you might sell 8 of the calls and take in $2400, leaving you with a nice 20% profit guaranteed ([$2400-$2000] = $400/$2000 = 20%), and a chance of making even more on the two contracts that are left in the trade. But don't let these calls go to zero. Develop a new exit strategy for the remaining contracts as if you were entering the trade for the first time. At this point, so long as your remaining calls don't go to $0, any price you sell them for is additional profit.

Another way to get a little more bang for your buck on this trade is to spread the remaining 2 calls by turning them into long verticals. By selling the next higher strike call against each of the remaining 2 contracts, you would take in more premium to bring you even closer to your initial 50% target, and still enjoy the upside juice the stock might have left. How? Suppose the next higher strike call is the 45 strike, and it's trading at $1. By selling 2 of them against your 2 long 40 calls, you take in a credit of $200, or an additional 10% of your original cost of $2000 for a total of 30% realized profit on the trade.

The remaining 40/45 call vertical trade has a chance of making another $5 for you. So your worst case scenario if the stock falls off a cliff, in that the remaining options go to zero, you keep a 30% profit (hurray!). The best case scenario is that the vertical spreads are cashed out at maximum value of $5 each and you take in another $1000, for a total of 80% on the trade (double hurray!).

Whether your problem is selling too soon or too late, it hurts all the same. Having made these mistakes on more than occasions than we care to admit, at some point, I figured out that taking your profits doesn't have to mean getting entirely out of the trade. The beauty of trading options is that when it comes to developing an exit strategy, you really can have your cake and eat it, too.

So, you get it now. If you have traded long enough, you have most likely been there, too. Your trade reaches its profit target, but you can't seem to pull the trigger to sell. And more often than not, the trade soon goes the wrong way - leaving your hard-earned profits in the dust.

When this happens, you might tell yourself that there's always another trade, right? WRONG! There is only the trade you're in. And to deny its full potential when it's right in the palms of your hands is a trading travesty. I know, I know... It's not as easy as it sounds. Were it merely an exercise in restraint, the advice would be easy (just don't be greedy!). But in trading, it's never easy. Money can do some funny things to your psyche. And when profits come easy, we have a tendency to think more is around the corner - if only we just wait a few more ticks...

THE VERTICAL SOLUTION!
Since we covered a couple of exit strategies already, let's talk about how to exit a long vertical spread.

Suppose you're long 10 call vertical spreads that you bought for $3 each, and you've met your profit target of $6. We can't think of a better reason for getting out of the trade than a 100% profit - except that it might go to 200%! (Sound familiar?) So, assuming you think there's some juice left in the trade, and you'd like to eke out more profits, what is the best way to exit the trade without leaving money on the table?

There are a couple of effective ways to solve this dilemma:

The first method is to simply "roll up" to another vertical at a higher set of strikes. In other words, close out the vertical you own and buy the next vertical in the options chain with the profit from the sale. This can be done at the same time or separately.

How? Suppose you own the 50/55 call vertical (long 50 call, short 55 call). Look out to the next set of strikes (55/60) and price those out. For simplicity's sake, let's assume the 55/60 call vertical is $4, a little more than you paid for the original vertical. Now calculate how many spreads you could buy using only the profit you made from the sale of the original vertical.

10 verticals x $3
= 10 x $300 = $3000
$3000 / $400 = 7.5

In this case, you simply round down to 7, which is the number of contracts you can buy using the house's money, so to speak. At this point, no matter what, you can't lose your original investment from the first vertical. And if you treat the new vertical as if it's an entirely new trade, barring an overnight collapse in the underlying, you certainly shouldn't lose more than, say, 50% (or whatever stop loss you would implement on the new trade).

The second method is this: If you double your money on a long vertical spread, and assuming you haven't already achieved the maximum profit possible, you might simply sell half of your position and manage the remaining trade as if it were a new one. This way, you remove the initial risk, and again, you're managing only the profit in the original trade. As long as you treat the remaining position like any other new trade, and don't allow the value of the spread to go to zero, you're once again guaranteed a profit.