Tales of a Technician: Return on Time Invested (ROTI)
It’s been about a year since I pontificated on the concept of return on time invested. And since I just had a profit target tagged in rapid-fire fashion, now is a perfect time to trot the topic back out and make sure any and all newcomers to the Tackle family are aware of its power.
At first, most traders learn that their goal is to maximize gains and minimize losses. After all, profits flow only if the sum of the winners is larger than the sum of the losers, right? While such a maxim may prove the best method for a stock trader or one wielding unlimited reward strategies (like long calls & puts), it’s not the best idea when selling options.
Suppose on April 16th we sold a May $46 put in EEM (the emerging markets ETF) for 50 cents. At the time May options had 32 days to expiration, and the implied volatility was perched at a modest 41%. If we end up riding to expiration to capture every last penny, we will make $50/32 days, or $1.56 per day. Some use the acronym PPD for Profit Per Day. On the bright side, we could then pat ourselves on the back for milking the entirety of reward from the naked put.
But should we not also consider the time element? What if we made the majority of profit, say $40 of the $50, in ten days? Would maximizing efficiency not argue for taking the money and running? It certainly would improve the profit per day! Capturing $40 over ten days translates into a $4 profit per day.
Think of it this way: If you can ring the register and capture $40 over ten days, then all you have to do is make more than $10 with the same capital elsewhere over the next 22 days to be better off. This is why I usually teach three profit target techniques for option sellers.
First, ride to expiration and capture the entire profit. This emphasizes maximizing gains but requires you to remain in the position longer.
Second, close the trade once you’ve capture the majority of profit (say, 80% to 90%). This acknowledges that it is inefficient to remain in the position the last few weeks just for the last 5 or 10 cents or profit.
Third, close the trade if you capture 50% of max profit quickly. This final tactic places the objective of maximizing profit per day front and center.
Here’s how each technique would apply to the short EEM May $46 put. Two days after I deployed the trade, EEM’s price popped and implied volatility dropped. The value of the put, initially sold at 50 cents, fell to 25 cents. If I were employing profit target number one, I would have let the position ride another 30 days, hoping that the put would remain out-of-the-money allowing me to capture the final 25 cents, and thus the entire gain of 50 cents.
Target number two would have had me waiting until the put dropped in value toward 5 cents. And number three would have directed me to ring the register and bail thereby locking in a 50% gain in two days. For those keeping score, that’s a mouth-watering profit per day of $12.50. Not bad considering the profit per day would dwindle to $1.56 if I held to expiration.
Aside from juicing the PPD, exiting at 50% of gain swiftly also affords the ability to re-enter if the stock sets up again. That is, sell the same put with the same expiry month. It’s the ultimate double dip.
The beautiful thing about EEM is that it has, in fact, come back down again. And, whaddya know?, the May $46 put is back up at 50 cents. Rather than making half of the gain, then seeing it disappear, I locked it in and now have the flexibility of jumping back in again if EEM starts to rebound.
Taking quicker profits is also prudent in a choppy, volatile environment like we find ourselves in now. As many have discovered, today’s gains can be quickly gone tomorrow.
Additionally, taking profits quickly also reduces your market exposure by limiting the duration of each trade. Holding a naked put for 40 days subjects you to more market risk than holding it for five days.
If you’re new to the game of option selling, try adding this technique to your playbook and let us know what you think.