Trade management falls into two camps – what to do with winners and what to do with losers. Today we’re looking at the first question, focusing on short options strategies. That includes the following: naked puts, naked calls, short strangles, bull puts, bear calls, and iron condors.

The first phrase I learned surrounding trade management was:

Maximize Gains and Minimize Losses

The Rookie’s Objective

The idea is intuitive. You want to make as much as possible on your winners so that they offset the losers. If I can increase my average gain from $75 to $100, then it should improve my overall results.

What’s missing from the phrase, however, is a time consideration. In the options market, this is especially important because risk can increase the longer you’re in the trade.

You have to balance the desire to maximize gains with the desire to reduce risk.

A sobering consideration

In the context of the above strategies, the risk we’re specifically referring to gamma risk. When selling options, you acquire negative gamma. That means your losses accelerate if the stock moves adversely. Since gamma increases as expiration approaches, the risk becomes particularly pronounced over the last few days of an option’s life.

This is one reason pros close their short options early.

Incentive #1 for closing short options early: You reduce gamma risk!

A second risk of holding the above strategies to expiration has to do with the slowing time decay of OTM options. This is a concept taught in our Cash Flow Condors course. Most traders are shown the following time decay curve when learning about how options lose value.

What’s often unsaid, however, is that the decay curve refers to ATM options. When we’re selling naked puts, credit spreads, condors, and the other strategies mentioned above, we’re using OTM options. And their time decay is slightly different then what you’re used to seeing. It actually slows into expiration. That means it can take a long time for the last 5 to 15 cents bleeds out of an option’s value.

Incentive #2 for closing short options early: Their rate of decay slows into expiration.

The third incentive is closely related to the second. Maximizing gains without considering the length of time it takes is foolish. For example, let’s say you sell a two-month naked put for $100. If you capture $90 in the first week, then you’ve pocketed 90% of the profit in 8% of the time. If you ended up riding to expiration, then you’d have to wait another 55 days (92% of the time) for the last 10% of the profit. That seems dumb, no?

Veteran traders don’t just look at maximizing gains. They look at maximizing their return on time invested. Making $50 in ten days is superior to making $100 in 30.

Maximize Return on Time Invested and Minimize Losses

The Veteran’s Objective

The assumption is that if you can redeploy your capital and make $50 every ten days, then you’ll earn $150 over 30. I’ve discussed the power of return on time invested (ROTI) in various articles (see here, here, here and here).

Incentive #4 for closing short options early: It improves your return on time invested.

Tastytrade has done a million studies on optimal management for short premium strategies. They usually use 45-day short strangles in their testing, because it’s the purest way to sell options (it’s delta neutral and only involves two legs). Over and over again, the conclusions support the rule of exiting at 50% of max profit. That means if I sold a naked put for $1.00, I’d buy it back at 50 cents. If I sold a strangle for $2.00, then I’d repurchase it at $1.00.

Exiting early captures the benefits already mentioned. Tastytrade quantifies just how early to exit by settling on 50% of max gain.

Incentive #5 for closing short options early: Because Tastytrade said so and they have data scientists.

What do I think about the 50% rule?

I have no problem with it whatsoever. In my playbook for short premium strategies, I have multiple techniques for profit-taking. Holding to expiration is the one I use the least. I almost always exit when I make most of my money (80% to 90%). I do tend to hold on longer than 50% in most trades simply because if they’re directional (like a naked put) and the position is behaving (e.g., the stock is trending higher), then why not just stay in with a tight stop?

The most common situation where I exit if I make 50% of max gain is if I make it quickly. For example, if I sell a 45-day naked put and capture 50% of it in the first few days, I’ll usually bail. The return on time invested is just too good to ignore.

One final point. If you’re going to take profits at 50%, you have to make sure you’re getting enough premium to make it worthwhile. I’m not going to sell a bull put for 40 cents and exit at 20 cents, because the profit’s not enough for me. But I would sell one for 80 cents and exit at 40 cents.

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