Closing Options Trades: When & How To Exit An Option Trade

Closing Options Trades: When & How To Exit An Option Trade

Closing options trades: "When should I exit a trade?" "How should I manage a winning options trade?”

There are quite a few misconceptions about the best time to close options trades (whether it's a naked option or a spread).

In this post, I will teach you how, and when, to exit an option trade.

First, I'll note that I believe that Tastytrade offers inaccurate information regarding exiting trades. They often recommend closing trades at 50% profitability (or 50% of the premium capture rate).

However, closing out both spreads and naked options at 50% of the premium collected is not optimal.

Here's everything you need to know about closing options trades, including when and how to exit an option trade:

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Closing Options Trades: Bad Information

Realistically speaking, what Tastytrade tells you is WRONG (in my opinion) because you're leaving a lot of money on the table.

Additionally, by entering trades at less than optimal times, you’re going to increase the probability of having to manage positions (my two BIGGEST criticisms of Tastytrade is that they trade way too often, instead of conservatively waiting for the best opportunities. The second major criticism of Tastytrade is that they do not deploy pro active hedges, leaving them susceptible to tail risk).

By following my option trading strategy and learning how to exit an options trade at the optimal time (and by hedging your positions), you will likely improve your returns.

This can be shown mathematically (as shown in the video above)

Key Points: Closing Options Trades

1

Close Out Your Trades Early

2

Patiently Wait for Great Opportunities

3

Close Naked Options at ~65% Profit and Spreads at 50% Profit

"This is how we earn our money when trading options. We close out our trades early, we only trade the most stable underlyings, and we patiently wait for great opportunities to present themselves." - David Jaffee, BestStockStrategy.com

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Closing Option Trades: Most Optimal Strategy for Managing Winning Trades

Now we're going to discuss how, and when, to exit an options trade.

When should you buy to close or sell to close?

Let’s use ABC Stock as an example.

ABC stock is trading around $130 per share.

Let’s say you sold a put option with a strike price of $120, and bought a $110 long put option.

Hypothetically speaking, you collect $3 of option premium on the $120 put, while the long put that you bought will cost $1.

By doing this spread you collect $2 in net premium, and by selling it naked you collect $3 per share, or $300 per contract.

According to Tastytrade’s recommendations, you should close out the spread at $1 and the naked option at $1.5 (closing out both positions at a 50% profit).

However, this does NOT make sense mathematically, and here is why:

The decay of the higher priced option (the option that you sell) will lead your profits.

It’s crucial to keep this in consideration.

When you close out the spread at $1, you will buy back your $120 put option at approximately $1.20 and sell your $110 put option for ~$0.20.

As a result, on a net basis your $110 put decayed $0.80 while your $120 put decayed by $1.80.

This is exactly where you’re leaving A LOT of money on the table.

Remember: the risk of the trade is with the short put. If you’re willing to wait for the $120 put on the spread to decay to $1.20, why wouldn’t you wait for the naked option to decay to $1.20?

The spread is primarily used for capital efficiency purposes and to control tail risk.

Yet, treating spreads and naked options the same in terms of when to close the trade doesn't make sense mathematically (and financially).

Giving up an incremental 10% - 15% of premium is not good trading. 

In this example, you should close out the naked option at 60% and the vertical credit spread at 50%.

My research has indicated that closing out naked options at a 60% - 65% profit and closing vertical credit spreads for a 50% profit is the most optimal way to make money when trading options.

If you close out all your positions at 50% then you're missing out on 10% - 15% of additional premium on every trade.

This adds up over time.

Closing Option Trades: Use Limit Orders

It is crucial to use limit orders with this strategy.

For example, let’s say you sell a $300 naked put option in Lockheed Martin for $2 of premium (or $200 per contract).

Immediately after the trade fills, you would then submit a buy to close, good-to-cancel ("GTC") order with a strike price of anywhere between 70 to 80 cents. This would allow you to keep 60% to 65% of the premium, 10% - 15% more than Tastytrade recommends.

If you wanted to sell a spread by selling the $300 put and buying a $250 put to collect net premium of $1, once this trade fills you would submit a buy to close order that would have a limit good-to-cancel price of $0.50.

Again, it makes no sense to close out spreads and naked options at the same price.

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Closing Options Trades Conclusion

When trading options, everyone has a different opinion on when is the best time to close options trades.

While I believe that selling vertical credit spreads will almost always be a better choice than selling a naked option (because it's more capital efficient and protects against tail risk), I believe it's best to close out spreads at a 50% profit and naked options at a 60% or 65% profit.

Leaving 10% - 15% of option premium on the table (when following Tastytrade's advice) is not smart.

For more information checkout BestStockStrategy.com.and enter your email address and receive over 50% percent over $400 worth of free options trading information.

Frequently Asked Questions (FAQ)

When should I close out an option trade?

In general, closing out a naked option at ~65% premium capture rate and a vertical credit spread at 50% is best.

When should I exit an option position?

In general, exiting an option position at ~65% premium capture rate and a vertical credit spread at 50% is best.

When buying options, when should I exit?

Due to theta decay, it's best to close out long options positions when you're showing a decent profit and there's still significant time left on the option.

If you're purchasing the option as a hedge, and not for speculation, then you can be more aggressive and hold onto the long option position. I discuss hedging and the best time to sell a long protective put in the options trading education course

About the Author David Jaffee

I (David Jaffee) help people become consistently profitable traders while minimizing risk. Learn more about our live trade alerts and courses. I graduated from an Ivy League University and worked at some of Wall Street's most successful investment banks. Subscribe to my YouTube channel for valuable videos - BestStockStrategy YouTube Channel​. My personal website is DavidJaffee.com.

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4 comments
Michael says July 11, 2019

I reviewed your July ’18 eTrade statement and I see a number of closing trades, on or close to the position expiration date, where it is closed for a couple of pennies. I understand your logic for taking profit at 65%, for naked positions, and would like to understand the thought process applied when you carry a trade to near expiration and presumably beyond the 65% profit point.

Reply
Alex says July 8, 2019

What do you advice someone who just started selling options do? I have a small account of $3,000. Planning on sticking to Robinhood until I build it more and then transfer somewhere else that will allow iron condors, strangles, and naked options. Currently I’m just doing bull put spreads far out of the money on stocks you recommend. Raytheon Lockheed Chase etc

Reply
    David Jaffee says July 9, 2019

    I’d recommend that you get comfortable with the strategy so that you can earn consistent profits. It sounds like you’re disciplined, which is great. I would also recommend signing up for Tastyworks. You can use this link and get a free week of my trade alerts once you fund your account with $2,000:

    https://start.tastyworks.com/#/login?referralCode=7R6QHPKFNC

    Reply
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