Managing our winners will be broken down into two categories. Being long or short premium presents different risk levels and solutions in managing that risk. Likewise, the rewards are different (long vs. short premium) and should be approached accordingly. Buying premium (long premium) by definition has unlimited profit potential. Conversely, selling premium (short premium) has a stated, pre-determined reward potential.

Category I: Long Positions

Outright Options – Anytime we own options outright, we know we have limited risk and unlimited reward, but when is an option considered a winner? As a general rule, when an option we own increases in value by 30%, it is considered a winner.

Once the option becomes a winner we will keep in place a moving average stop loss of 10%. Let’s look at a simple math problem to make sure we understand a 10% profit vs. a 10% stop loss.

We buy an ABC call and pay $5 for the option. The $5 premium is $5 x 100 shares of ABC stock, so we have a debit (cost) of $500. If the call price goes in our favor by $150 (to a price of $6.50) we now have a 30% profit in our trade an it is classified as a winner. Once a trade is a winner we will never accept a loss! We immediately place a stop at breakeven: $5.00.

If the trade goes to a price of $6.50 we would move our stop up to $5.85 which is 90% of current price, and a 10% stop loss ($6.50 x 10% = $.75). Each time the price moves in our favor we will move the stop up by a corresponding amount of 10%. If the price went to $8.50, our stop loss order would be $7.65.

We manage the position in the same manner until we are finally stopped out and we start all over again with a new trade.

Should the option increase rapidly, even doubling in value, one can sell half the position managing the remainder until stop out.

Long Spreads – In this case, let’s look at another example for illustration. We own an ABC $10-$15 vertical call spread. Our cost is $1 ($400 total debit). Spreads offer a limited profit potential. In this trade, our total profit potential is $400 and our potential loss is $100. Because our gain is limited, we need more profit before the trade can be considered a winner. The trade will not be considered a winner until it has a gain of 30%. Once a trade is a winner we will never accept a loss! We immediately place a stop at break even.

If the trade goes to a price of $2 we would move our stop up to $1.80 which is 90% of current price, and a 10% stop loss. Each time the price moves in our favor we will move the stop up by a corresponding amount of 10%.

We manage the position in the same manner until we are finally stopped out and we start all over again with a new trade.

Should the option increase rapidly, even doubling in value, one can sell half the position managing the remainder until stop out.

Category II: Short Positions

Outright Options – Selling (writing naked options) has unlimited risk; the reward is limited to the credit that we take in. In this example, we are going to sell the ABC call for $5. A short option is considered a winner when the price decays by 25%. Before writing naked options, understand the risk and enter a concurrent stop loss order with the initial option sale. Due to their high degree of risk, we do not recommend writing naked options for the typical trader. For those that do however, the same general rules apply.

Once a trade is a winner we will never accept a loss! We immediately place a stop at break even.

If the trade goes to a price of $3 we would move our stop down to $3.30 which is 110% of the current price, and a 10% stop loss. Remember, when we are short options and we are stopping out, the price will be inverted as we will elect our stop above the current price; buying the options back at a reduced price from the purchase. Each time the price moves in our favor we will move the stop down by a corresponding amount of 10%.

Short Spreads – In this example we are going to sell an ABC 10-15 vertical call spread and receive a $4 credit. This example is much different than selling an option outright, but managed like the long vertical position. In this trade, our total profit potential is $400 and our potential loss is $100. Because both our gain and our loss is limited, we need more profit before the trade can be considered a winner. The trade will not be considered a winner until it has a gain of 30%.

Once a trade is a winner we will never accept a loss! We immediately place a stop at break even.

If the trade decays to a price of $3 we would move our stop down to $3.30 which is 110% of current price, and a 10% trailing stop. Each time the price moves in our favor we will move the stop down by a corresponding amount of 10%. Remember, when we are short options and we are stopping out, the price will be inverted as we will elect our stop above the current price. Each time the price moves in our favor we will move the stop down by a corresponding amount of 10%.

We manage the position in the same manner until we are finally stopped out and we start all over again with a new trade.

Should the option increase rapidly, even doubling in value, one can sell half the position managing the remainder until stop out.

Managing gains is the best part of trading. Traders should not err on either side of managing profitable trades. Don’t watch a gain while not protecting it with either moving your stops or placing a trailing stop. We prefer trailing stops be utilized only after a gain is locked in above approximately 40%.

Do not err on the side of hope as well. Stop losses should be at least in your strategy and identified before a trade if entered. We advise the stop loss be entered concurrent with the position open.