Exit discipline is the hardest part of the trade. A trader who enters a position correctly and manages the position correctly can still lose money if the exit is wrong. The exit discipline is the mechanism by which the position's expected value is realized, and the exit discipline is the part of the playbook that most traders struggle with.
We use OptionsStrat for visualizing option strategies. The platform shows the risk/reward profile, breakevens, probability of profit, and Greeks across every spread structure used in the playbook.
Disclosure: this is an affiliate link. The journal may earn a commission if you sign up. The recommendation is on the merits — the journal uses OptionsStrat daily and would recommend it without the affiliate relationship.
The take-profit rule
The journal's take-profit rule is to close the position at 50% of max-profit for short-premium structures and 50-100% of max-profit for long-premium structures. The 50% rule is the foundation of the playbook's exit discipline, and the rule is applied to every position without exception.
The 50% rule has two justifications:
1. The time value of the remaining premium. The second 50% of max-profit takes roughly as long to collect as the first 50%, but the position's risk (the max-loss) is the same during the second 50% as it was during the first 50%. The risk-adjusted return on the second 50% is lower than the risk-adjusted return on the first 50%, and the journal's rule is to close the position when the risk-adjusted return is no longer favorable.
2. The behavioral risk of holding the position. The longer the position is held, the more likely the trader is to override the playbook's rules. The trader's judgment is most likely to be wrong at the end of the position's life, when the position is close to max-profit and the trader is tempted to hold for the full profit. The 50% rule is the journal's way of removing the behavioral risk from the most common override scenario.
The exceptions to the 50% rule are documented in the playbook's adjustment rules. The exceptions are: (1) positions with less than 7 days to expiration, where the remaining time value is small enough that holding to expiration makes more sense than risking a reversal on an early close; (2) positions that are delta-neutral at the 50% mark, where the journal may hold the position one more day to capture the residual time decay; and (3) positions that the journal wants to roll forward to the next expiration because the underlying thesis has not played out yet.
The stop-loss rule
The journal's stop-loss rule is the position's max-loss for credit spreads and 50% of max-loss for debit spreads. The max-loss rule is the foundation of the playbook's risk management, and the rule is applied to every position without exception.
The journal does not use a hard stop-loss order on every position. The reasons are: (1) a stop-loss at the max-loss would fire only when the position is at max-loss, which is information the journal already has; (2) a stop-loss below the max-loss would force an exit before the thesis has had time to play out, which is usually the wrong decision for short-premium structures; (3) the journal's position sizing is designed to absorb the max-loss, so the journal is prepared to take the loss.
The debit spread's 50% stop-loss is the exception. The reasoning is that the time decay on a long-debit position works against the journal, and the longer the position is held, the less time it has to recover. A 50% stop-loss on a debit spread is the analog of the 50% take-profit on a credit spread: limit the time spent underwater.
The early-close rules
The early-close rules are the rules for closing a position before the target or the stop. The early-close rules are mechanical, and the rules are applied to every position that meets the criteria.
1. Trade invalidation. When the position's thesis is invalidated by a market move outside the structure's expected range, the position is closed regardless of the position's current P&L. The trade invalidation is the journal's rule for exiting a position when the underlying's behavior is no longer consistent with the structure's expected behavior.
2. Volatility regime change. When the implied volatility changes by more than 30% during the position's life, the position is closed regardless of the position's current P&L. The volatility regime change is the journal's rule for exiting a position when the structure's edge has degraded.
3. Earnings announcement. When an earnings announcement is scheduled for the underlying during the position's life, the position is closed before the announcement. The earnings announcement is the journal's rule for exiting a position when the underlying's behavior is about to become unpredictable.
4. Correlation breakdown. When the position's correlation with the rest of the portfolio changes by more than 20% during the position's life, the position is closed regardless of the position's current P&L. The correlation breakdown is the journal's rule for exiting a position when the portfolio's risk profile has changed.
The early-close rules are documented in the playbook's adjustment rules. The rules are mechanical, and the rules are applied to every position that meets the criteria. The journal's rule for the early-close rules is that the rules are not discretionary: the rules are applied to every position that meets the criteria, and the application of the rules is documented in the trade log entry.
The most common reasons traders exit too early or too late
The most common reason traders exit too early is fear. The trader is afraid of losing the unrealized profit, and the trader closes the position before the target is reached. The fear is most common at the 25-50% mark of the position's max-profit, where the position is in the money but has not yet reached the target. The trader's fear is not justified by the playbook's rules, and the trader's fear is the source of the position's underperformance.
The most common reason traders exit too late is hope. The trader is hoping the position will recover from the loss, and the trader holds the position past the stop. The hope is most common at the 50-75% mark of the position's max-loss, where the position is underwater but has not yet reached the stop. The trader's hope is not justified by the playbook's rules, and the trader's hope is the source of the position's worst-case outcomes.
The journal's view is that the exit discipline is the most important part of the playbook. The journal's process discipline is the mechanism by which the trader is held accountable to the exit rules, and the journal's monthly methodology audit is the mechanism by which the exit rules are evaluated.
The exit discipline in the methodology audit
The exit discipline is reviewed in the monthly methodology audit. The audit computes the realized exit distribution: the percentage of positions that closed at the target, the percentage that closed at the stop, the percentage that closed early, and the percentage that are still open. The audit compares the realized exit distribution to the expected exit distribution, and the audit identifies the patterns that are not consistent with the playbook's rules.
The journal's rule for the exit discipline is that the realized exit distribution should be within 10 percentage points of the expected exit distribution. The expected exit distribution is computed from the trade log's historical data: the percentage of positions that historically closed at the target, the percentage that historically closed at the stop, and the percentage that historically closed early. The realized exit distribution is computed from the most recent month's data.
A realized exit distribution that is significantly different from the expected exit distribution is a sign that the trader is not following the exit rules. The audit's corrective action is to identify the specific exits that are not consistent with the rules and to revise the trader's behavior. The audit's long-term corrective action is to revise the rules if the rules are not producing the expected exit distribution.
The exit discipline in the position-level review
The exit discipline is also reviewed in the position-level review. The review identifies the exits that were not consistent with the playbook's rules, and the review identifies the exits that were not consistent with the position's thesis. The review is the journal's first line of defense against pattern drift in the exit discipline, and the review is the mechanism by which the trader is held accountable to the rules.
The journal's rule for the position-level review is that every exit is reviewed. The review is a short note (3-5 sentences) that captures the exit's reasoning, the exit's consistency with the rules, and the exit's impact on the position's expected value. The review is documented in the trade log entry, and the review is the basis for the monthly methodology audit.
The journal's view is that the exit discipline is the foundation of the playbook's risk management. The exit discipline is the mechanism by which the position's expected value is realized, and the exit discipline is the part of the playbook that most traders struggle with. The journal's process discipline is the mechanism by which the trader is held accountable to the exit rules, and the journal's monthly methodology audit is the mechanism by which the exit rules are evaluated.