Intermediate
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Options Theory: Why Close a Naked Put at 50%

December 24, 2020

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Pro Members have exclusive access to 31 powerful trading strategies categorized according to the Options Greeks. Bullish, bearish or neutral market conditions, this Playbook will help you trade with greater confidence.

Last update: August 2021

Hat tip to Coach Cody for suggesting this week’s topic.

One of the beauties of selling premium via naked puts, covered calls, and the like is that the market effectively tells you your target. Unlike an open-ended trade such as long stock or long calls where your profit is theoretically infinite, these types of strategies offer limited gain. Thus, your max profit is known from the get-go, and the pressure of guessing how high the stock will rise is removed.

  • If you sell a put for $100, then $100 is the entire profit available.
  • If you sell a call for $50, then $50 is the maximum gain.
Options Theory: Why Close a Naked Put at 50%

Trade Management in a Nutshell

The first time I learned about trade management while sitting at the feet of the masters that came before me, I was taught a simple phrase,

“Maximize your gains and minimize your losses.”

Trade management in a single sentence

The logic made sense. After all, trading is a numbers game where you and I try to make more on the winners than we sacrifice on the losers. At the end of the day, month, year, or whatever, if (sum of gains > sum of losses), we win!

And, since not all trades are winners, we must do our best at milking the ones that do come our way so we can squeeze every last ounce of profit. We can’t let a good trade go wasted, in other words.

Viewed through this lens, my job when managing a naked put that I sold for $100 is to capture the entire $100. Otherwise, I’m not “letting my winners ride,” which is another way of articulating the idea of maximizing gains.

And yet, I wonder if we’re missing out on what could be a superior method of management in our effort to grab every last penny, one that considers the effect of time.

The Return of ROTI (Return On Time Invested)

Would you rather make $100 over 50 days or $50 over 10 days?

Here’s a handy formula that calculates profit per day, or PPD for short, to help you answer the question.

PPD = Profit / Number of Days in Trade

Those who obsess about maximizing gains would shoot for the $100. After all, $100 is more than $50.

Well, not so fast. Let’s look at the Profit Per Day of both cases.

  • $100/50 days = $2 per day
  • $50/10 days = $5 per day

Note how capturing $50 in a mere ten days translates into a PPD of $5. Essentially, the market front-loaded your return. It gave you 50% of max profit in 20% of the time. It’s like a payday advance.

When you start to look at PPD, it opens your eyes to the concept of return on time invested or ROTI.

If I can capture $50 in ten days and then redeploy my capital elsewhere, all I really need to do is capture another $50 over the ensuing 40 days. I’m still just as well off as if I remained in the original position to milk the entire $100.

But if all goes well, I may make another $50 in only ten days. Do that five times, and all of a sudden, you’ve made $250 in the same 50 day period it would have taken you to capture $100.

Now you see the wisdom of velocity of money and turnover. If you’re a good trader, then you’re incentivized to turn over your capital as much as possible. Those with an eye toward PPD and ROTI always look to lock-in profits quickly when they get them.

Then rinse, wash, repeat.

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One Reply to “Options Theory: Why Close a Naked Put at 50%”

  1. ROBERTMCKEE says:
    December 25, 2020 at 8:47 pm

    Thanks for clarifying the intuitive but otherwise vague concept of maximizing returns.

Comments are closed.

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