How to Draw Down an Option Position

Taking an option position off correctly counts for more than putting a position on. Let’s talk about ways to do that.

When I speak of an option position, I am talking about an options spread. Trading options outright is seldom an advisable way to trade. When you own options outright, time decay can crush your position even if you have the direction right. And selling options outright carries far too much risk for the reward.

Remember that ease of exit is more important than ease of entry. Only have positions in liquid series with good volume, a narrow bid/offer spread and a large open interest.

Have a good reason for exiting a position. Taking a profit is not necessarily a good enough reason. A good buy is no excuse for a bad sale.

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For instance, let’s say that you are long with a vertical call spread, the stock goes higher and you are thinking of closing the position. Ask yourself if you would go short with that spread at the price you are thinking of closing. If not, you should reconsider.

A caveat to that is doing what is known as “taking a double”. That means that anytime you can sell half of your position so that the other half is free, do it even if you think the stock or index will keep going your way. There are some good reasons to do this.

First of all, if you take a double you are now playing with the House’s money and who doesn’t like that? Next, there are few worse feelings than seeing a winning position turn into a loser without having taken anything off the table. It is basically sound money management and helps you keep your trading discipline. And both of those are keys to successful trading.

For example, let’s say I buy a put butterfly for $1 ten times and it is going my way. The very first moment I can sell the butterfly five times at $2, I will do so. Regardless of where I think the stock is headed. I now have a free position no matter what the stock does.

Taking a small loss before it becomes a bigger loss is a good reason to reduce or close out a position. Having said that, beware of over adjusting, particularly if there are still some weeks to go in the position. Assuming you are in an options spread, you knew the risk and reward going in and found the potential loss acceptable at the time. Over adjusting only makes your broker money.

An exception is if you have a position in deep-in-the-money American style equity options and there is danger of an early assignment. You do not want your inexpensive options to turn into expensive stock, long or short.

Another key to drawing down your position is to always buy back any short option when it trades at .05 or lower. To do otherwise is just plain greedy. After all, you sold it for more than .05, right? Go ahead and leave that last nickel on the table.

It is never advisable to carry a position all the way to expiration. Funny things can happen on expiration. And your position has either worked by now, or not. Trade out the day before expiration, at the latest. And leave expiration day to the professional traders.

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