Professional option trader Tyler Craig explains how he manages a popular option trading strategy to achieve maximum profit potential.

As traders, we all face the dual mandate of maximizing gains and minimizing losses. Long-term profitability is a byproduct of the simple formula: big winners + small losers. 

Unfortunately, the mere acknowledgement of such a trading aphorism is just the beginning. The devil, as they say, is in the details. And since nothing illustrates the details like an actual example, let’s walk through an attempt at maximizing gains on a recent bear put spread.

In accordance with my bearish disposition on VXX outlined in a November entitled The Comeuppance for VXX Bulls, I opted to enter a few bearish spreads including the purchase of some January 44-39 put vertical spreads on December 8 for $2.79. 

The max risk was $279 and the max reward was $221. The dual forces of contango and seasonality delivered a swift beatdown to VXX, dropping it from $43.50 on Dec. 8 to $36.25 on Dec. 20.

See related: The 4 Key Seasonal Trends for 2012

The vertical spread rose in value from $2.79 to $4.00 for a gain of 43%. With the underlying down eight days in a row and the spread boasting a notable gain, I faced the typical dilemma of deciding whether or not to take profits or adjust the trade.

I opted for the latter due to two primary reasons:

  1. The initial risk-reward of the position was $2.79 to $2.21—a ratio of 1.26 to 1. After the spread rose in value, the risk-reward became $4 to $1—a poor ratio of .25 to 1. Although I could have remained in the position in an attempt to capture the last $1 of profit, thereby “maximizing my gains,” the risk/reward ratio was less than ideal

  2. With the notable drop in VXX to $36, the Jan 44-39 vertical spread had moved $3 in the money. This had the effect of dropping the overall Delta of the position, making the additional accumulation of profits a slow process. At trade inception, the Delta per spread was -20.  Following the drop to $36, the net Delta had dropped to -13

To improve the risk/reward ratio, increase the net Delta of the position, and better maximize gains if the downtrend continued, I elected to roll the vertical spread down and out. That is to say, down to lower strike prices and out to a later expiration month. I closed the Jan spread at $4 and bought a February 38-33 put vertical spread for $2.85.

The new position offers a better risk/reward ratio $2.85 versus $2.15 and has a higher net Delta, allowing the accumulation of quicker profits if VXX continues to sink.

If you regularly employ vertical debit spreads and have yet to add rolling to your repertoire, consider this your invitation. It’s a tactic which strikes a nice compromise when faced with the dilemma of how to best maximize gains.

NEXT: Another Trader Weighs in on This Strategy