Arguably as important as choosing an options strategy trade to open is having a plan for ending the trade: win, lose, or draw. Managing trades is critical to long term success. Management strategies fall into the three categories of holding, folding, or rolling. Many traders use only one of the three approaches, often by default or habit, without considering what strategy is best for each trade. So when is it right to hold, fold, or roll?
In Kenny Roger’s classic song, The Gambler, he sings:
“Every gambler knows that the secret to surviving is know what cards to throw away and knowing what to keep… You’ve got to know when to hold ’em, know when to fold ’em, know when to walk away, and know when to run….”
Trading options is similar in some ways to playing poker. There’s a randomness to it that requires adapting to the hand that is dealt. There is the ability to adjust, and a time to hold on, and a time to get rid of a position. Sometimes, it is best to take off a winning position and walk away, and sometimes a trader needs to get out of a losing situation quickly. However, trading isn’t the same as gambling, in that we can choose our starting positions where a poker player can’t, and we can choose strategies that have a positive probability of profit. And we have one very different choice, we can roll from a position that has made its profit or is losing, to a different position that we like better.
Let’s quickly define what I mean by hold, fold, or roll. Holding an option to me means keeping the position until expiration. Many people that start trading options don’t know there is any other choice. However, many traders like to fold their positions or close them early. This can be to cash in a winning trade, to prevent a loss from getting out of hand, or simply to reduce risk as expiration approaches. Rolling is the process of simultaneously closing an existing trade and opening a similar trade at different strikes or different expirations. The trade lives on, but with some combination of additional time or better strikes for the latest market conditions. I will argue that there is a place for each approach, but as Kenny Rogers might say, “you’ve got to know when to hold ’em, know when to fold ’em, AND know when to ROLL them.” Let’s dig deeper into each one, and then circle back to when to pick each one.
Holding to expiration
By default, if an option trader doesn’t do anything, the option will expire at the end of expiration day. At that point, it will either be worthless, or have a value equal to how far it is into the money. If the option is in the money, it will almost certainly be exercised or assigned. For owners of options, many brokers automatically execute the option at expiration, although some may close a position in the final hours if settlement of the option would result in a negative cash balance, or being short in a hard to borrow stock. Knowing what a broker will do with in the money options at expirations is a consideration for traders holding any position that is close to being in the money at expiration.
For option buyers, many times a trade just doesn’t work and as expiration approaches there is little value left in the option. At that point, closing the position won’t net much, and there is still a chance that the market may reverse and get the option back into the money, so why not hold on? Worst case, the option loses the last little bit of value at expiration.
For option sellers, expiring worthless is often the goal. Everyone knows that premium decays more rapidly as expiration approaches and getting all the decay means holding on until the end. (As we’ll shortly discuss, this common knowledge is not always true, but for now, we’ll go with it.) Options close to the money, either slightly in the money or slightly out of the money as expiration approaches, retain a significant amount of extrinsic value. This is because it is unknown whether the option will be in or out of the money at expiration. For traders that are okay with either outcome, holding to expiration allows them to keep all that extrinsic value as the final days go by. Many short sellers don’t mind being put stocks or having shares called away at expiration, so holding to expiration is a great strategy.
There are downsides of holding to expiration. For option buyers, time decay makes many strategies hard to profit as expiration approaches. Even when an assumption of movement is correct, time erodes the extrinsic value, often faster than the gains achieved from price movement. Winning trades can also turn to losers on a price move that is unexpected, with no time to recover. For example, imagine buying a call for a dollar and having the stock move two dollars in the money the day before expiration. But, then on expiration day the stock drops by two dollars and fifty cents and all the gain is lost. The option could have been closed at a profit, but it got away.
For option sellers price movements near expiration can turn an option that was expected to expire worthless to expire in the money and end up being exercised. And options that are far out of the money generally have little value for days or even weeks prior to expiration- holding those short positions doesn’t gain much decay, and exposes the seller to the risk that some strange event might bring the nearly worthless option back into the money.
When is it a good time to hold to expiration? I think of this as, when would I put on an option trade, and plan not to do anything to it, no matter what? I look at a couple of criteria. First, is the risk to reward ratio at a level that a total loss is tolerable? Let’s say a trade has a max loss of $100, but a max profit of $1000. This might be a good trade to let ride. On the other hand, a trade that risks $1000 to make $100 may not be good to hold without additional management. Tastytrade recommends selling spreads where a trader collects one-third the width of the strikes. Why? Because if someone collects one-third the width, they are risking two to make one, but on a fairly high probability trade. For example, a trader may sell a 30 point wide spread for $10. They could make up to $10, but losses are limited to $20 if the trade goes completely through the strikes.
A second criteria to consider is the extrinsic value of the trade and how time decay impacts the position. If time decay is working for the trade, then holding all the way to expiration may not be a bad idea. If someone sells an out of the money credit spread, time will work to make it decay to zero if the price cooperates. Many traders like to let these trades expire worthless, avoiding commissions and trading fees to close the position. Even debit spreads can be set up to have positive decay. Generally, if the long option is in the money and the short option is at the money or close, the result will be the short option decaying faster than the long, which makes the trade positive, even if the price doesn’t move. Since decay often accelerates as expiration nears, a position that decays in a favorable way can make a lot of sense to hold until expiration.
A final reason to hold to expiration is that the trader may want to have the option exercised. Perhaps, the trade was to sell a cash secured put with the goal of buying shares that are put to the trader at expiration, or a covered call was sold with the goal of having the stock called away. Generally, for that option to be exercised, it needs to be held to expiration. Many option traders use this strategy intentionally to get in and out of positions.
Holding an option to expiration is a viable strategy in many situations. However, because it is the default outcome, many traders use it without thinking about alternatives or realizing the potential benefits of managing a position before expiration.
Folding or Closing Early
There are many reasons to fold or close a trade early. Folding sounds like a bad thing, but often it is more like taking money off the table, to use a gambling expression. An option trade has done what the trader wanted, so close the trade and move on. Or maybe the trader wants to close a position based on time in the trade or an amount of time remaining before expiration to reduce risk as expiration approaches. And sometimes, when things aren’t going well, the best thing to do is close a trade, cutting losses before they get out of hand. Each of these scenarios deserves more attention and discussion as a method to manage and close a trade early.
Many trading strategies involve the concept of setting profit targets and then closing the position when the target is met. This concept goes against the trading axiom of letting profits run and cutting losses. Many think that taking off winning trades reduces the overall potential profit of a position. However, the thing to remember is that we are talking about options, and options have a set time to expire. This time factor introduces an additional element of risk, the risk that the trade may reverse its gain prior to expiration without time to recover.
In many option trades there is also the concept of diminishing returns-if someone sells an option, the limit of profitability is the amount of premium collected and if most of the premium has decayed, what is the point of staying in the trade and maintaining the risk? For example, if a trader sells a put for $2.00 in premium with two months until expiration, but the option premium drops to $0.05 after a month, does it make sense to hold on another month to make the final $0.05 decay and take the risk that the stock price could reverse and wipe out the win? Most people would decide that closing a trade that has collapsed that big is the right choice.
But what if the premium has decayed to half its initial value? Let’s say that a trader sold a 10 point wide credit spread for $1.00 premium six weeks prior to expiration. The maximum loss is $900, and the maximum gain is $100 for the contract. Let’s say that after two weeks, the premium has dropped to $0.50. Now, the trader has the possibility to make $50 more or lose $950 in the next four weeks. What should the trader do? Likely the probability has improved that the position will expire worthless, but that is four weeks away. Personally, I’d close the trade and find something else to use my capital for.
It’s a personal preference, but many look at targeting a set amount of profit based on what is possible for the risk being taken and the nature of the option strategy. When I trade broken wing butterflies, I like to target closing when my premium has decayed 90%, but when I trade put credit spreads, I only target premium decay of 50%. Why the difference? It’s just the nature of how decay works in each trade and how much I think is reasonable for the risk of the trade. Since most credit trades I do are based on collecting premium and letting it decay with a high probability of success, I almost always target a profit to get out of a trade. At some point, the remaining premium isn’t worth the risk of holding any longer. Plus, by using limit orders, I can close even when the price just briefly hits my target.
When I use the term folding, most people think of it as giving up, or cutting losses. Most successful traders are very familiar with this process, as they don’t want a single position to cause a huge loss that ruins their account. Particularly when possible losses are high compared to the potential profit, it often makes sense to limit the amount that can be lost. This strategy is known as a stop loss. A stop loss can be an actual trade where the trader sets an amount to trigger closing the position, or it can be a mental trigger for the trader to close a position when the position goes too far as a loss.
My entering an actual stop loss order, the decision is made ahead of time, so there is no second guessing when the order is triggered. For example, if a trader sells a put for $1.00, they might enter a $3.00 stop loss order, wanting to lose no more than twice the amount collected. There are a couple of potential problems with this order. First, with option pricing, a stop order might get triggered when liquidity is low and the bid-ask spread gets wide. Depending on how the broker manages stops, a stop loss might get filled when prices don’t warrant it. This can particularly be a problem when trading spreads or multi-leg option strategies. In fact, some brokers won’t even allow stop losses on option trades other than just one leg positions to avoid inadvertently filling an order that shouldn’t be filled. The other issue with a stop loss order is slippage. If the price of the position is moving quickly, when the stop order is triggered, there may not be anyone willing to buy or sell at the stop price, so the trade price may slip into a bigger loss. For our trader that had a $3.00 stop loss order, they may get filled at $3.50 instead during a big market move. So be aware that stop loss orders may not always work as expected, but they can generally get a trader out of a losing position.
Because of limitations of stop loss orders, some traders choose to manually close their positions when a loss limit is hit or even approached. This allows the trader to control the entry of the trade, but it also requires that the trader be on top of the position, using alerts or actually watching the trade. For short duration trades, some traders that manually stop their positions physically sit and watch prices on their screen all day. For others that have long duration trades, maybe a daily check of the position is enough. In any case, the problem of inadvertently triggering a trade can be avoided, but the problem of slippage still exists. When the position hits the limit and an order is entered to close, the order may have to be moved to a bigger loss to be filled.
Stopping losses is an imprecise process. Traders can’t get out exactly at a pre-determined limit every time. Since option prices are more volatile than the underlying stock on a percentage basis, fairly small moves in the option’s stock price will move the option price significantly. Perhaps a 1% stock move may cause an option to double or cut in half. Traders have to understand how much movement is to be expected in the option price before setting a stop price. Often the brokerage platform will have an analysis feature that allows the trader to get a good estimate of how moves of different amounts in stock price will impact the option price prior to expiration.
Another way option traders fold their positions early is by exiting at a pre-determined time-frame prior to expiration. Why would someone do this? Well, knowing that option premium in near the money strikes decay rapidly near expiration, but are also very prone to large swings in value, closing early takes away the drama of expiration. This can be true for both option buyers and sellers.
Option buyers know that if their option expires out of the money, it will be worthless. If the option strike price is very close to the current stock price as expiration starts to get close, it may still have a lot of extrinsic or time value left. It may make sense to sell the option and pocket that time value and look for a new position that has more time to make a move. Many option buyers buy options with lots of time left that won’t have a lot of time decay, and then get out while the time is still plentiful. There are a variety of strategies that try to prevent time decay from being a major drag on a purchased option, and most involve avoiding expiration.
Option sellers want time decay, don’t they? Why would they want to exit a set time before expiration? For many strategies that sell options with plenty of time left, options are sold well out of the money with the expectation that the time value will decay away. Perhaps the goal is for half the premium to decay away in one third of the time before expiration or maybe half the time. By the time the target date arrives, if the profit goal hasn’t been met, then the risk of bad outcomes starts to rise, while it is unlikely that large losses will have occurred. The prudent result is to close the trade, freeing up capital and reducing risk, and allowing a new trade to use the capital if desired.
One common method of trade management is to use all aspects of folding or exiting early, a profit target, a stop loss, and a time limit. For example, one trade I often do is to sell a put at 90 days to expiration with a 15 delta strike. I set a profit target of 60% decay of the premium collected. I set a stop loss at 200% of the premium collected. And if neither of these occur, I close the trade after 30 days or when there are 60 days left. Historically, this trade on the S&P 500 wins over 80% of the time, and averages keeping about 25% of the initial premium, while closing about half the time after 30 days and half the time sooner.
So, which early closing strategy or combination is best? It depends on the strategy and the time frame. Some strategies require holding much longer than others, and some have bigger profit targets. One method I use to help decide is to backtest a strategy using different early closing tactics and see which one or combination works best. I may try a variety of profit targets, or different stop losses, or different timed stops. I may see that one type of exit early worsens results, while one or two others improves results. Then I test combinations of the most promising set-ups to find the most optimal historically. Back-testing can’t predict the future, but it can give a good indication of what has worked in the past and will likely work in the future under similar circumstances. An easy free back-test software to try is Lookback by Tastytrade.
For strategies where I exit early or fold, I keep detailed logs that help me see how each of my current trades are performing, and why and when I closed each of my old trades. Then I can act on my existing positions with data, and I can also review how my strategies have played out over time.
Rolling- keeping the trade going
Rolling option positions is one of my favorite methods of managing trades. Why? Since I like to sell options and collect Theta, I often just want to stay in a position continuously, so that it continuously decays. Rolling a position allows me to keep the trade going. Rolling is the process of simultaneously closing an existing option position, and opening another one with the same strategy but with more time, or more favorable strikes in the same expiration.
Many people are confused by the concept of rolling for a number of reasons. The concept can be a little overwhelming at first, and it is often mis-represented as an always bad way to manage a trade. At it’s simplest, it is a way to add more time to a trade, and making money doing so.
Let’s start with a fairly simple example. Many option traders like to sell covered calls, but don’t want their underlying shares to be called away. One way to stay in the trade and not have the option exercised is to roll the call to a later expiration before it gets too close to expiring. A trader could start by selling an out of the money call with 6 weeks until expiration, and hold on until there a 2-3 weeks left, then buy back that call and sell the same call strike with a month more time. After another month, the trader does it again. Each time, the longer dated call will sell for more than the one that has decayed, so the roll will net a cash credit to the trader’s account. If the underlying price moves, the trader can change to a different strike during the roll, potentially still collecting credit while moving to a higher strike. By rolling continuously, the trader always has time decaying the call, no matter what the price does. I do a 7 DTE trade that I roll continuously, as the primary management strategy. There are some other things to consider, but the concept of rolling keeps the position always active.
Rolling in many ways is similar to exiting early or folding that we previously reviewed. We can roll based on winning, losing, or a set time. For example, I roll my credit put spreads in the 45-21 DTE timeframe using all three criteria. I have a profit target that when met I roll out to around 45 DTE at new ideal strikes. I also have a loss limit where I will roll out and roll down my strikes to give the trade more time to recover. And finally, if the trade gets down to 21 days remaining to expiration, I roll out to keep the trade going and avoid expiration drama.
Rolling gets a bad reputation as a way to lock in losses when rolling a losing trade. It is true that when a trade is rolled, the old trade is closed and that trade has either made or lost money. The new trade starts out with its own new starting value. However, many people who roll will track an adjusted cost basis for the combination of the old and new trade. If a credit was collected in the roll, that credit is added to the cost basis of the old trade and considered the cost basis of the rolled position. Then all profit targets are based on a comparison of the current premium to the adjusted cost basis.
Rolling losing positions is not for the feint of heart. A trader needs to have good reason to believe that the trade will recover the amount lost in a reasonable amount of time, and have the capital available to keep the trade going until things turn around. Often, traders give up at the worst possible time taking huge losses, because they are tired of fighting, or they run out of capital.
Learning how to roll positions in different situations is a great trading strategy to master. It isn’t the solution to every situation, but it can keep a trade alive indefinitely, which is a neat trick to know with options that are always decaying toward expiration.
Conclusion- Hold, Fold, or Roll?
Knowing when to hold, fold, or roll takes time and practice. But, most of all it takes knowledge of the advantages and disadvantages of each approach.
