Put Path 9 The End: How To Close Out Your Trades and Assignment Risk

So now you have started, you’ve got a couple of trades on, and you wonder “what’s next”? Well, you need to understand how to close out positions. Don’t forget, every stock trader wants to “Buy Low, Sell High”. In our case it’s a slight variation, we want to “Close Low, Open High”. It’s really the same thing because when you are opening the spread, your profit driver is selling the Put position. So, you want that selling Put to be valued high (Open/Sell High). Remember, when volatility is high, we want to sell options. So, typically we like to close out positions when they have only $.01 or $.02 value left (Close/Buy Low). This way you can maximize your profits and get the positions closed out as early as possible. I used to leave the positions open all the way to expiration, but I find that the closure at $.02 is more effective. You are taking risk off of the table and freeing up Buying Power, and it’s only costing you $2 per lot. If you leave the options contracts open all the way to expiration, there is always a chance that the market could have a sharp reversal, and these positions could gain value and potentially even turn into losers for you.

We always close options that move In The Money. If one of your positions ever gets In The Money, then close it immediately. There are rare occasions where some positions can move In The Money, but still not be a 2X Loss. In these cases, we always close them out. We close them because they will likely be losing positions and to avoid Assignment Risk. Assignment occurs when the put option buyer exercises, forcing you to fulfill their obligation and you must buy 100 shares at the strike price. If your short position ever gets Assigned, I recommend that you exercise your long put or sell the shares and close the long put at the same time. This will preserve your capital so you can fight another day. There is also a rare scenario where the option could move In The Money after market close and you end up getting assigned after the close! If the stock price were to continue to go down in the after market, you would lose whatever the potential loss value is for that stock loss, which can really blow out your account (and you could lose more than the max loss for the spread). So, it’s really important that you close out short options before expiration. I like to put the $0.02 close order in immediately after I get confirmation of open execution. It sets a positive expectation mindset and that way I can set it and forget it. Either way, you must double check that all of your positions are closed before or on expiration day.

Alternatively, sometimes you will have to close out positions at a loss. This can be hard for some people, but this discipline is essential!!! If you start to get anxious and close it out too early, you can actually turn a winning trade into a loser. Some other folks don’t ever want to close positions because it locks in their losses. So, they try to roll them or leg out or just acquire the shares, which is not recommended as this ties up your capital inefficiently. Some people cannot stomach losses, so it’s important to understand your own psychology and be disciplined in your approach. I can tell you that losses are part of this system. They are welcome and expected. We trade at 85% probability of profit (-.15 Delta). So, the inverse of that is you should have around 15% losses. Just accept the loss and move on. Look at it like you minimized your loss by closing the position, and it’s just bringing you that much closer to your next profitable trade. Many times, we will be closing losses and opening trades simultaneously during times of volatility. It’s healthy to have losses and it is critical to be able to mentally accept these losses. If you are trading all 12 underlyings, you will average 2 losses per week long term. They typically are clustered in times when we move from low volatility to higher volatility, but this helps set your expectations. On an average week, just expect to lose 2 trades. This will help you mentally prepare for the loses. Over time, the math works and the percentages are in your favor (POP/Delta on the model is solid) and you will win around 85% or more of your trades. We have an efficient stock market (I ascribe to the efficient market theory), and the Black-Scholes is an efficient options pricing model. For example, long term I have calculated that my losses are about almost exactly at the expected value. Which means if we trade at an 85% POP, I am measuring around 85% actual winners.

What influences the winning percentage? Sometimes having to close out losers early at a 2X (200%) loss can bring the % down, but many times volatility is overstated so we have actually achieve higher than an 85% win percentage. Over time I’ve seen the win percentage vary from 82% all the way up to 92%, but 85% is the expected value. When we close at a 2X loss, keep in mind that these positions will still have no intrinsic value. We are closing them pre-emptively with the extrinsic value calculated by the market. If we always held to expiration, we would likely be at least an 85%-win percentage. So why not hold all of them to expiration then? Because some of your losses will get too large, which will more than offset the 2-3% that you close too early. We close out losers at 2X in order to cap the loss and preserve capital. After a position gets over 2X loss the loss tends to grow exponentially because of the math. Conceptually, as the underlying is steadily going down it moves quicker from a 2X to 3X loss and then it accelerates even quicker from a 3X to 4X loss. It is essential to close out at a 2X loss, or this system will not work as well. You could even lose money with it. Trust me, make 2X a rule and stick to it. It’s good for your mental game and financial gain. Once your position breaches 200% loss or 2X, then put in your close order. Then monitor the order. Chase the market price and close it out…immediately!!! Increase your price loss until it closes. Do not wait for the market to turn. Do not put in an order and wait if the market comes back to you. Hope is not a strategy. Walk your price up steadily by placing closing order after closing order until it executes. This is essential and I can’t emphasize it enough! Don’t play games with your money. You don’t want to take large losses and blow out your account. So what if it’s a 2.1X or 2.2X loser or 2.5X loser, just close it. It takes all of the emotion out of the trade. The indecision, fear and worry then goes away. Stick to the mechanics of the trade and you will feel better, and more importantly you will make more money over time.

So what is an example of a 2X loser? Let’s say we opened a QQQ trade for 28 days out and collected a credit premium of $.50. Two weeks later QQQ starts to decline and decline and decline each day. At the end of the third day of sharp decline that spread is now worth $1.50, then you need to close it out Immediately. You would lose $100 net on the trade, which is 2X your original credit of $50. With TastyTrade you look under “P/L Opn%” or Robinhood you just display your positions using “Total Percent Change”. When it hits -200%, it’s time to close. Again, don’t think, just do. You’ll feel better after you close out the losers. I have also noticed that the losing trades come in waves. Typically, market pressures affect many of your positions or at least many of your stock ETF underlyings. Thankfully, we have some built in protection against large losses because of laddering and system diversification through various underlyings and expiration dates. I have also tinkered with many points along the 1X through 3X loser close out strategies, but the math does not work as well, and they are less profitable long term.

OK, that wraps up the Put Path. If you stick to the system, you could get up to 50% Annual Rate of Return. Some years I exceed 50% and some years I’m a little under, but that is the baseline scenario. You may not achieve that in the real world unless you unswervingly follow the system, but I have proven that 50% is certainly realistic. I’ll walk you all through the math on that in later posts. I have seen around 50% annual rate of return on capital for several years and that is our target. Hopefully this Put Path has been helpful. If you need more instruction, continue to read the blog posts, watch the videos and read options books. I definitely recommend becoming a Member and getting the Real Time Trades. Additionally, I am developing a full Put Path Course to include in depth training so stay tuned!