Just as option traders need to manage and evaluate losing trades and follow-up plans, they also need to decide what actions should be taken when profits exist. There are basically three forms of action available to the trader when dealing with profits. The option trader can simply take the profits and close the position, he can exercise the options, or use the profit cushion to create new strategies.
The first method is the most obvious one. The trader simply closes the position and takes the profits. For instance, if the trader is long on a call or a put, they can sell and the remaining difference is their profit. If they have a short position, a closing purchase transaction also generates profits. In either situation, the decision to close, frees up the risk exposure and capital, allowing them to then seek out a new position. This makes it possible to transfer risk to another position that appears more promising in terms of potential profits. It is also important for the trader to identify a profit target and to take action when that target is reached, because profits can certainly appear and disappear quickly.
If the trader has a long position, they go ahead and exercise the option and then develop additional strategies employing the stock position with other option strategies. With long position options there are three possible outcomes. First, if the value of the underlying stock never exceeds strike price, it will expire and be worthless. Next if the position is profitable, it can be sold and profits taken.
Finally, an in-the-money [ITM] option can be exercised. For instance, if the trader is long, the call "options" with the idea that those calls fix the price in the event of exercise, but do not require commitment of capital in the event of a loss. Those traders who purchase options for the purpose of exercise will either buy 100 shares of stock at the fixed strike price of a call, or they will sell 100 shares of stock at the fixed strike price of a put.
The other method available to the options trader involves using existing profits to augment their current position, such as the creation of expanded spreads. This is more of an advanced approach and certainly consists of the most sophisticated outcome scenario. The contingent purchase strategy is most profitable when the underlying stock value increases well before expiration and when the trader enters into a spread by selling higher strike calls. This strategy produces several key advantages.
First, the cash received for selling the call reduces the original cost of buying the first call. Second, it is covered in the sense that, if exercised, the trader can employ the long call to satisfy the assignment, creating an automatic profit. Third, by timing the short positions well, the trader gets maximum time-value decay between opening the position and expiration. In fact, the trader could sell a number of covered calls against the long call during its life span, and still exercise the long call, which is typically a LEAP and purchase the stock.
This is just one type of scenario, however, there are a variety of combinations that can be employed to further enhance a profitable position. In fact, this should encourage the new options strategist to map out a few scenarios of their own so they can acquire these profitable adjustment skills.
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