lystn

Hey everyone, Kirk here again at Option Alpha and welcome back to the daily call. On today’s daily call, I want to answer the question quickly – “How exactly do you calculate profit targets?” I think although it seems intuitive for most of us, it might actually be something that you just want to double check as you’re going through your trades and just make sure that you understand how exactly you calculate these profit targets. Now, why do we talk about profit targets? Well, we understand that the concept of taking trades off early really helps us out in our long-term returns and win rates. It helps us out in reducing drawdowns, just this idea of managing positions or removing positions earlier in the expiration cycle. Now, I would say that each profit target level may depend on the exact time that you enter the trade, the strategy, where implied volatility is, all this stuff. There’s no one size fits all, meaning that there’s not always going to be say a 25% profit target for everything. It really depends on the setup. That's why we built out the trade optimizer which you can learn more about at optionalpha.com/toolbox. It's a piece of software that basically allows you to input the current market information and then it tells you exactly when you should get out of that trade. It gives you your profit targets or your stop losses or all of that stuff in advance of actually building out the trade, so you know – Hey, if I get into this trade because I’m 30 days to expiration and implied volatility is X and I’m trading a strangle and I’ve got a retirement account versus a margin account, it’ll tell you what the most optimal exit target is for that particular position. And so, again, it depends on the market situations just so you guys know. When you’re calculating profit targets though, I think it’s actually pretty easy to do, but I want to walk through an example here on the daily call just because I do get sometimes questions on this and I want to make sure people have clarity on it. When you're calculating profit targets, it’s usually based on percentage. In today's example, we’ll just use 25% profit target as our example. Again, it could be 75%, 50%, different levels based on where the trade optimizer and back testing shows, but today, we’ll just use 25%. If we’re going to get into an option buying strategy, then profit targets are pretty easy to calculate. You basically take whatever premium you paid and multiply that by 1.25, one point the profit target that you’re going to use. In this case, you increase the value of that by 25%. If we pay let’s say $1 to get into some sort of spread and we buy a spread, so we do a debit spread or something like that, we pay $1 and we have a 25% profit target, we’re just going to multiply that $100 premium by 1.25, one point the profit target that we have. Now, if we had a 50% profit target, we’d multiply it by 1.5. If we had a 75% profit target, we’d multiply it by 1.75. We’re just increasing the value by 25% or 50% or 75% because that's our profit target. We want to make that much money on the trade before we exit. If we pay $100 for a spread and we multiply it by 1.25, then we know we’re going to exit the position when it goes up to $125. Again, it’s a very easy calculation on that end. It’s probably the easiest one which is why we start with it. And then you can place your automatic closing order, your contingency order to remove the position whenever it gets to that level. On the sell side now, when you're selling options, it’s a little bit different because when you're selling options as a net strategy, you want the value of those options to go down. If we sold a position for $1, then we want to take it off once it's gone down in value by 25%. If we still have the same 25% profit target, we’re now taking off the position when it goes down in value by 25%. How do you calculate that? Well, the first way you could do it… This is not the most efficient way, but this is I think how most people think about it initially and I’ll offer up a better alternative. The first way you could think about it is you could calculate 25% of the value and then subtract that amount. 25% of $100… If we sold something for $100, 25% of that is $25. You subtract $25 from the value that you initially paid and you get $75. Once the value of the strategy goes down to $75, we would take the position off. Again, you can setup an automatic contingency closing order to do this for you. But that's really inefficient because it is two steps. You have to calculate 25% and then you have to subtract that from the value. It's easy when we’re talking about it in just simple math terms here with $100 and $25, but what if you sell an option for $326 and that’s the capital that you took in? It’s not as easy math to do. The other alternative then is just to multiply the value of your contracts that you sold. In this case, we’ll just use still a $100 premium. We're going to multiply that by 1 minus the profit target. In this case, if our profit target is 25%, 1 minus .25 is .75 or 75%. If you think about it, you’re going to take the position off when it's 75% of the initial value or a reduction in value of 25%. That's the way I think about it. A position comes off when the price is now 75% of what I paid for or it reduced by 25%. In this case, we would take 100 and we’d multiply that by .75 and that would get us the same $75 value. Again, this is a lot easier to do because like I said, if you sell something for say $326… You can hear me clicking around because I’m actually just doing the math on the calculator because I can’t do it in my hand to do it that fast. But if we sold something for whatever it is, $326 and then we multiply that by .75, we would take the position off around 244.5. When the position goes down in value and it’s now worth 244.5. Again, then you can round up a little bit or round down. You don’t have to do the half, $.50, etcetera. I think that helps out and hopefully this walkthrough has been helpful to you in just understanding how you calculate these. Do them a couple of times, make sure that you're doing them right and then just honestly place those automatic closing orders to remove the position. Automate the backend as much as humanly possible which I think ultimately helps out. If you guys have any questions on this, let me know. Until next time, happy trading!