For many directional traders, the question “when to take profit” is one of the biggest dilemma. It can go in the trader’s mind like this: “The stock has increased in price and I am currently $100 in plus. Is it already enough? Should I close the position now? But what if the price increases even more and might miss a $500 profit. $500 would be good as I made some losses with my previous trades where the stop loss order was triggered. But what if the price goes down and from the current winner will be suddenly a losing trade? Should I better close the trade now and take those $100?“
We definitely want to avoid doubtful thoughts like that. Hence, the need to have a rule when to take profit.
When selling an option, it is not difficult to decide when you will take your profit. The reason is that as soon as you sell an option, you will receive money (premium) for the option upfront. This premium is the maximal profit you can make with this trade. This fact saves a lot of troubles for option sellers. (Please note: You cannot immediately withdraw the money and run as there is still your sold option. The sold option is your liability and this might increase in value).
Taking profit in practice
An option is similar to an insurance against increasing (call option) or decreasing (put option) prices.* The option buyer paid you a premium and you as the option writer took on yourself a temporary obligation to sell or buy.
Taking as an example Apple stock, which currently costs about $160. We sell a put option with a strike price being $145 with the expiration date in 30 days. We did that because we think that the price will not go below $145. If it went, we would have the obligation to buy the stock for $145 once the option holder decides so. The premium that we received for this option was $100. If everything goes fine, that is to say, the price of Apple does not move much or it goes up or it moves very slightly down. Then, the price of the put option will begin to decrease over time. These are good news since the aim is to buy back the option for example at 50% of its original value and hence make 50% profit. In this case, that would mean $50 (minus commissions).
There is no need to wait 30 days until the option expires worthless, in particular when the option lost most of its value. You will see that, in many cases, you will be able to buy back the previously sold option just after few days with 50% profit. In option selling, I have always fixed percentage of profit I want to make. This differs depending on the types of option I sell. You can define your own value. It does not need to be 50%, but from experience of a number of experts and studies made on this subject, 50% is a good point where to buy back stock options. Once you have your defined point, stick to that in every trade.
Constant profit taken in a consistent way
Having rules when to take profit makes our actions more systematic and restricts our emotions. In general, emotions are not a good adviser at the financial markets. Greed brings people to buy overpriced things and fear makes people sell when prices are low. The big advantage of rules is that they force us to act against emotions. If a certain thing happens, we act in a certain way. Mechanically and uniformly without unnecessary doubts.
*To find out more about options, check out the “OPTIONLAND”.