Options Trading: How to Cut Your Losses in Half (2024)

Mitigate downside risk by exiting early

When it comes to options trading, managing risk is crucial for long-term success. It’s particularly important when trading undefined risk strategies such as naked puts or strangles to understand that strategic exits can make a substantial difference. Let's delve into how exiting positions at 21 days to expiration (DTE) can be a game-changer.

One of the main concerns for active investors is the magnitude of potential losses. By exiting SPY options positions at 21 DTE instead of holding them until expiration, the largest losses can be cut nearly in half. Specifically, the largest losses decrease by almost 50%. Moreover, average long-term losses drop by an impressive 60%. This practice is crucial for improving control over downside risk, making your trading experience more predictable and less stressful.

Consider a scenario where a SPY Strangle incurs a potential loss of $1,000 if held until expiration. By exiting at 21 DTE, this loss could be reduced to approximately $500.

The loss-to-credit ratio is another key metric. It indicates how much potential loss you're facing compared to the initial credit received. By managing positions at 21 DTE, traders can often cut this ratio in half. For 90% of occurrences, the loss-to-credit ratio remains below 2. This means that in most cases, the losses are less than twice the original credit received, providing a more balanced risk-reward profile.

If the initial credit received for a SPY strangle is $200, exiting at 21 DTE ensures that in 90% of instances, the loss would be less than $400.

Trading strategies are often stress-tested during challenging market conditions. Historical data from periods like 2008, 2018, 2020 and 2022 show the benefits of exiting positions at 21 DTE become even more pronounced during significant market downturns. In these periods, the largest risks can be reduced by up to 75%, providing a substantial buffer against market volatility.

Key takeaways

Exiting options positions before expiration can be highly effective in mitigating large losses. This strategy is especially valuable during turbulent market conditions, offering traders the opportunity to manage volatility and protect their portfolios.

By adopting the practice of exiting positions at 21 DTE, active traders can significantly enhance their risk management, ensuring a more stable and less anxiety-inducing trading experience.

Kai Zeng, director of the research team and head of Chinese content at tastylive, has 20 years of experience in markets and derivatives trading. He cohosts several live shows, including From Theory to Practice and Building Blocks. @kai_zeng1

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