"Scaling out" is inferior behavior

[Maverickz]

I think scaling out can be good depending on what you are trading. I like to do it occasionally with option spreads. Why? With option spreads you have a limited downside and at times you can scale out just enough to cover any potential loss in the remaining position so that you have in essence a risk free trade, because no matter what the underlying does you can no longer lose money. Yes you are to a degree "leaving money on the table" but at the same time if the underlying then moves against you, your "insurance" you bought by scaling out would have been superior to "letting it ride" but worse that getting out entirely with more of a profit.

In short we can see scaling out is inferior if the market continues to move your way, but superior if the market moves against you. So how do you know when to use it? Trading is based on probabilities. You only entered when you felt you had a strong probability the market would move a direction and maybe it did move in your direction but started losing steam so the probability of continuing that direction was reduced, but not by enough to warrant a full position closure. Scaling out can be seen as a representation of reduced probability in one direction but not enough to represent a confident change in direction.

 

[BONECRUSHER]

I think scaling out can be good depending on what you are trading. I like to do it occasionally with option spreads. Why? With option spreads you have a limited downside and at times you can scale out just enough to cover any potential loss in the remaining position so that you have in essence a risk free trade, because no matter what the underlying does you can no longer lose money. Yes you are to a degree "leaving money on the table" but at the same time if the underlying then moves against you, your "insurance" you bought by scaling out would have been superior to "letting it ride" but worse that getting out entirely with more of a profit.

In short we can see scaling out is inferior if the market continues to move your way, but superior if the market moves against you. So how do you know when to use it? Trading is based on probabilities. You only entered when you felt you had a strong probability the market would move a direction and maybe it did move in your direction but started losing steam so the probability of continuing that direction was reduced, but not by enough to warrant a full position closure. Scaling out can be seen as a representation of reduced probability in one direction but not enough to represent a confident change in direction.

I haven't traded options in a LONG time...never option spreads. Please tell me why you don't trade these MORE and thus scale out of option spreads more frequently? In theory, limiting losses in any instrument is a solid foundation to any successful methodology...just continue refining for optimal profitability...right...maybe? Just curious.

 

[Maverickz]

I haven't traded options in a LONG time...never option spreads. Please tell me why you don't trade these MORE and thus scale out of option spreads more frequently? In theory, limiting losses in any instrument is a solid foundation to any successful methodology...just continue refining for optimal profitability...right...maybe? Just curious.

First it doesn't always make sense to scale out of a spread trade because by their nature your loss is limited regardless of what happens. I like selling spreads on weeklies of major ETFs (SPY, DIA, QQQ, IWM, TLT, etc.) so I am looking at relatively short time frames anyway (3-7 days). Say My position is a Bull Put Spread (credit spread that makes money based on time decay if the underlying goes up or stays above my short put strike ). 2 days later the underlying has moved up strongly with lots of volume, my probability is still high of keeping my full credit (max win), I see no reason to scale out. If on the other hand it has moved up only a little or stayed put on low volume so the probability of continuing up is reduced, I will look to scale out to a zero loss scenario. If the probabilities start shifting to the downside depending on various indicators, I will just exit the entire position taking what ever profit I have.

This is why I love options so much. In no other trade I can think of can you enter with a specific defined maximum loss already known and wind up with a zero loss scenario with proper trade management.

 

[BONECRUSHER]

First it doesn't always make sense to scale out of a spread trade because by their nature your loss is limited regardless of what happens. I like selling spreads on weeklies of major ETFs (SPY, DIA, QQQ, IWM, TLT, etc.) so I am looking at relatively short time frames anyway (3-7 days). Say My position is a Bull Put Spread (credit spread that makes money based on time decay if the underlying goes up or stays above my short put strike ). 2 days later the underlying has moved up strongly with lots of volume, my probability is still high of keeping my full credit (max win), I see no reason to scale out. If on the other hand it has moved up only a little or stayed put on low volume so the probability of continuing up is reduced, I will look to scale out to a zero loss scenario. If the probabilities start shifting to the downside depending on various indicators, I will just exit the entire position taking what ever profit I have.

This is why I love options so much. In no other trade I can think of can you enter with a specific defined maximum loss already known and wind up with a zero loss scenario with proper trade management.

THANK YOU SIR!

 

[md2324]

Maverickz,
Can you please give a real world example of how this would work via trading Options Spreads..... I.E. the ZERO Loss way in which your strategy works.

I love Options and spreads as well ..... Just trying to make sure I understand the way in which to set myself u for a Worse Case Scenario for a Zero Loss on a Spread trade

And can this only been done with Credit Spreads ? What about Debit Spreads ?

I like Debit Spreads, for the fact that in theory, you can get into an Options trade fairly cheaply via putting on a Debit Spread, and then Closing out the sold portion of the spread by Buying-It-Back and thus Leaving the LONG option open , to capture Unlimited/Maximum profits.
Of course very specific variables have to play out in order for this to work .....1. the option has to have moved far enough above ( for a BullCall spread ) the Bought Call, and the sold call will have had to deterioate enough to buy it back for pennies
2. You will need to have enough time ( perferably 45 days or more ) left till expiration..... at the point that you can buy back the sold call for pennies, thus giving your now LONG Call enough time to gain in value as your trade keeps going UP in your favor , as to avoid the time decay to expiration being so close, that even though the trade is moving up in your favor, it can't overcome the decay via Time decay to your Long Call

Thanks so much

 

[Maverickz]

Maverickz,
Can you please give a real world example of how this would work via trading Options Spreads..... I.E. the ZERO Loss way in which your strategy works.

And can this only been done with Credit Spreads ? What about Debit Spreads ?

It should be doable with both. I will try to give a Bull Call example below. I just checked the current option prices for SPY in ThinkOrSwim for the 13th May Weeklies. (Yes I know longer time frame is better for Bull Calls but this is just a calculation example.)

With Spy closing today at 204.97 if you think it will go up you could have bought Bull Call Spread using a Long 203 Call and a Short 204 Call for a net of $.68 per contract or $680 for 10 contracts. Max Profit $320, Max Loss $680. (Probably not optimal strikes but again not really relevant to the calculations.)

Now assume that in three days time the underlying has moved up in your favor by $3.03 to $208. If you are no longer confident that the underlying will stay high enough to reap max profit, at this point you should be able to liquidate the entire position for about a profit of $190 out of the possible $320 OR scale out. In this case if you sell 8 of the 10 spread contracts for $152 ($19 * 8) leaving 2 contracts on. Your max loss/win is now -136/64 but since you already locked in $152 even at a "max loss" scenario you still technically made $16 ($152-136). In a Max profit scenario you made a total of $216 ($152 + $64) instead of only $152. So in the end you "risked" only making $16 in order to make an extra $64. Is that worth it? In this particular case probably not because we had to sell too many contracts to reduce the risk to 0 or less. Hopefully you can see how to calculate it and decide if it is. As you can see, it doesn't always work out but sometimes it works out fairly well. Doing Bull Calls, a longer time frame (like you said) rather than the weeklies I was looking at, as well as optimizing entry strikes will probably make a difference in how well this works. Although for Bull Calls I think I would want more like a 90 day time frame (rather than 45) to reduce Theta exposure. It also may work better with Credit spreads since time is working for you in that case. You will just have to play with the numbers and see. Also be sure to figure in commission costs as this can affect whether or not it is a good decision.

I like Debit Spreads, for the fact that in theory, you can get into an Options trade fairly cheaply via putting on a Debit Spread, and then Closing out the sold portion of the spread by Buying-It-Back and thus Leaving the LONG option open , to capture Unlimited/Maximum profits.
Of course very specific variables have to play out in order for this to work .....1. the option has to have moved far enough above ( for a BullCall spread ) the Bought Call, and the sold call will have had to deteriorate enough to buy it back for pennies
2. You will need to have enough time (preferably 45 days or more ) left till expiration..... at the point that you can buy back the sold call for pennies, thus giving your now LONG Call enough time to gain in value as your trade keeps going UP in your favor , as to avoid the time decay to expiration being so close, that even though the trade is moving up in your favor, it can't overcome the decay via Time decay to your Long Call

All of that is true but I still prefer selling Credit spreads. Using a Bull Put Spread instead of a Bull Call Spread, you take in money when opening the position, time works FOR you instead of against you. Shorter time frames (weeklies) means time works for you FASTER and can mean cashing in more often...every week. You are still looking to buy back the short position for $0.05 or less just for protection sake if the underlying moves your way. If the underlying starts moving against you, you COULD close the short position early allowing the long position to reap unlimited profit if the underlying moves far enough against you. Kind of a "WOW I was wrong" insurance. Although trading weeklies this hasn't happened to me...yet.

Finally I feel should also say in full disclosure, I have only done this like twice. Call me a chicken, but if I can lock in ~75% of my target profit in the first 2 or 3 days, I usually lock it all in, count my blessings, and start looking for the next trade. I just wanted to point out that with options, it is possible to scale out and end up where it is impossible to lose money on the trade. I don't think this is possible using any other trading vehicle.

PS: I did this at 2:25 am, after a few drinks, if my math is at all wrong, please forgive me. If this is as clear as mud, let me know, I can try to explain again later...after some sleep.

 

[Maverickz]

I haven't traded options in a LONG time...never option spreads. Please tell me why you don't trade these MORE and thus scale out of option spreads more frequently? In theory, limiting losses in any instrument is a solid foundation to any successful methodology...just continue refining for optimal profitability...right...maybe? Just curious.

As I explained in my reply to md2324, I have only done this a couple of times because for it to work you usually need to have already made a pretty good % of the potential profit anyway and I most often choose to take the money and run at that point rather than to be greedy and try and wring a few more bucks out of the deal. Think of it this way. If you have already made 75% of your target potential, you can either take that 75% or scale to a point where you can make an additional ~5% with zero risk capital (based on the original trade). I should point out that scaling out like this does mean that your account cannot drop below where it was before the initial trade was put on (thus the zero risk) one could argue that by scaling out you are in fact still risking the profit you locked in already for the additional return and from that perspective you will never be risk free. How you look at it is up to you.

 

[BONECRUSHER]

As I explained in my reply to md2324, I have only done this a couple of times because for it to work you usually need to have already made a pretty good % of the potential profit anyway and I most often choose to take the money and run at that point rather than to be greedy and try and wring a few more bucks out of the deal. Think of it this way. If you have already made 75% of your target potential, you can either take that 75% or scale to a point where you can make an additional ~5% with zero risk capital (based on the original trade). I should point out that scaling out like this does mean that your account cannot drop below where it was before the initial trade was put on (thus the zero risk) one could argue that by scaling out you are in fact still risking the profit you locked in already for the additional return and from that perspective you will never be risk free. How you look at it is up to you.

MAVERICKZ.......Thank You!

 

[ktm]

I've traded spreads for many years and also scale out, but in a different way.

I may start with a fairly wide spread, or overlapping spreads - let's say on ES and we open a 2000/2040/2080 butterfly. The first part of a butterfly (2000/2040) might be worth $28 when I put it on. I will enter an order to move the 2000 to 2005 when I can get 4.50 for it...or sometimes 4.00 depending on a number of other factors. The upper half might be worth $-17 or so. I'll do the same there but in 10 point increments, taking the 2080 down to 2070 for $1. This continually compresses the spread and reduces risk while increasing profit potential.

Of course everything is capped because it's a spread. The theory here for me is to take profit when I get 80% to 90% of the max and remove potential losses when I can cover them for 10% to 20% of the max.

Three things that are crucial to this.

1) Your may need to add spreads as necessary when the market doesn't cooperate and this is just an example to make a point about scaling

2) If you do this, you need a broker with low commissions

3) Whether it's 80%, 90% whatever, you should find the number that makes you comfortable and pair it with spreads that also fit your personality in terms of risk etc...

Scaling out may be "inferior behavior" with some products and some strategies, but it's the key to profitability for what I do.

 

[Maverickz]

@ktm,

That is a form of rolling not scaling but yes that is a very valid move as well. Rolling is closing positions and reopening new ones to continue the trade. Scaling is closing of positions to lock in some profit while leaving some of the positions on to continue the trade in a reduced capacity.

Similar to what you are doing with the butterflies, I like to do similar things with tight sideways underlyings. I start with a double diagonal (looks like an IC with the shorts in the front month and the longs in the back month) then roll into an IC once the front month expires. This allows you to sell the shorts twice while only purchasing the longs once. Of course you need to have a reasonable expectation that the sideways trend will continue that long but it is a really nice play.