Good Trade Management Pays For Itself
New tastytrade research shows how the implementation of a disciplined trade management approach can help traders avoid outsized losses—especially during severe bouts of market volatility
In order to consistently book profits, traders must pair good ideas with effective risk management practices—the latter of which includes everything from trade deployment, to trade management, to trade exit.
Within the trade lifecycle, the most difficult decision making tends to revolve around when to exit a trade. Should winners be allowed to run, building on momentum? Should losers be cut off early, before they get out of hand?
As it relates to trading options, the tastytrade financial network has conducted extensive research on the topic of trade management (i.e. when to exit a position), and this information provides valuable insight for traders looking to refine their approach.
One good starting point when it comes to effective trade management is the adoption of a disciplined, mechanical approach.
This type of consistent, objective thinking can help traders avoid some of the errors associated with a one-off approach that’s steeped in emotion. Listed below are some guidelines traders can lean on when building a more mechanical approach.
Traders can also utilize various trade management tactics to help optimize risk management.
New research conducted by tastytrade demonstrates how the implementation of a disciplined trade management approach can help traders avoid outsized losses—especially during severe bouts of market volatility.
But prior to jumping into that research, readers may want to familiarize themselves with some of the more common trade management approaches, as outlined below.
Trade management: Managing winners/losers or managing early
Two of the most prominent philosophies on trade management involve managing trades based on profit and loss (P/L) and managing based on time. At tastytrade, these approaches are often referred to as “managing winners/losers” and “managing early.”
At its core, managing winners/losers is all about closing positions while they are ahead, or before they get too far behind—and doing so consistently and mechanically.
A couple of well-known approaches to managing winners include closing strangles at 50% of the credit received, or closing straddles at 25% of the credit received. In the case of the former, that would mean if one sold a strangle for $2.00, the strategy would call for closing the position once the market value of the strangle had decayed down to $1.00.
The graphic below highlights some rules of thumb traders can refer to when building an approach for managing winners.
In terms of managing losers, things get a little trickier.
Research conducted by tastytrade suggests that managing losers can help reduce losses and the volatility of portfolio P/L. However, managing losers also cuts into the theoretical probability of profit (POP), meaning that one’s overall expected probability of profit can be negatively impacted when managing losers.
That’s because options trades—particularly short options positions—have a tendency to fluctuate between profit and loss, especially early in the expiration cycle. Research on this subject has shown that patience can be key with such trades, and that holding such trades through those difficult moments can often pay off, as illustrated below.
But if managing winners/losers doesn’t fit one’s outlook and risk profile, investors and traders can also choose to manage early by closing positions systematically at predetermined points in time.
Traders utilizing this approach frequently close positions after a certain number of trading days have elapsed, or with a certain number of days left until expiration. At tastytrade, managing early generally refers to the latter philosophy: Closing trades based on the number of days left until expiration.
The managing early approach is predicated on the fact that the P/L per day tends to decrease as positions get closer to expiration, particularly for short options that are in-the-money (ITM) or out-the-money (OTM), as shown below.
The managing early approach may be attractive to investors and traders seeking the following benefits in their trade management framework:
- Minimizing overall risk
- Maximizing daily P/L
- Minimizing outlier risk
- Redeploying capital quickly
- Increasing the number of occurrences
Readers seeking additional information on trade management philosophies can review the following links:
- Market Mindset: Why We Manage Trades
- From Theory To Practice: Managing Winners and Losers
- Tasty Extras: The Benefits of Managing Early
To learn more about the overall value of an effective trade management strategy—particularly during periods of extreme market volatility—check out this new installment of Market Measures on the tastytrade financial network.
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Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to firstname.lastname@example.org.