Every properly designed  income options strategy should have both a target profit and a maximum loss. Both are extremely important in order to maintain a realistic annual return target for a particular strategy. The skilled income trader is both disciplined at exiting when a trade has hit the  maximum loss threshold and skilled at what we alluded to in my last blog post as the “milking” phase of a successful options trade.

“Milking” is our name for positioning an income options trade, once the target profit has been hit, to conceivably take advantage of further profit potential as a result of the decay of time premium on our short options, while protecting most of  our achieved target profit. As I’ve mentioned in the past my personal practice is to do whatever I can to virtually lock in 75% of my target profit once hit. Here is the process that I use to “milk” an options trade:

1. In a very disciplined manner I wait for the target profit of the trade to be hit. Income trading doesn’t work if you fail to either let your profits run or cut your losses short.

2.  Regardless of the time of day, if my target profit is hit, I immediately go into “milking” mode. I do not wait for the market to drop back below my target. Once I get a fish on a hook, I don’t like to let it go.

3.  I then utilize my options analysis  software to make the following calculation: I   determine what a one day/2 standard deviation move would be on the stock or index that I am trading in either direction. I will adjust the volatility setting a few points upward for a sell off and a few points downward for a rally. Changing the volatility settings is important and often overlooked by developing traders—they tend to look at the “scary looking” T+0 curves without focusing on the reality of what would happen to volatilities in various price movement scenarios.

4.  I then fool around with the trade in some way so that a 2 standard deviation move would not remove more the 25% of the target profit achieved to date. One of the easiest ways to do this is by simply cutting the lot size of the trade down taking some of the risk off of the table. However, that approach has the drawback of removing a great deal of time decay potential from the trade. I prefer instead to shave portions of the trade off that are creating the most downside risk and keeping as much of the capital as I can at play leaving as many of the short options on the table as possible in order to maximize continued time decay. So for example, if I have a double calendar trade on and I am leaning long deltas, I might remove some of the upside calendar lots to cut deltas in the event of a 2 standard deviation down move.

5.  I then monitor the trade  daily and, once or twice a day, depending on the overall situation, I will measure the maximum profit level that the trade had attained at any point after we entered the milking phase, take 75% of that number, and do whatever is necessary (and often that is nothing) to assure that, again, a 2 standard deviation move or less will not remove more than 25% from the highest P&L that we had attained at any point since the trade was initiated.

6. This process continues then every day until the market finally stops us out, or we have decided that our capital should be deployed more wisely into the next month’s trade.

This process will often result in 5-10 more return points above the original target profit percentage and is therefore a worthy exercise to master.

Seth Freudberg

Director, SMB Options Training Program