While selling options is a high probability trading approach, when trading undefined risk strategies we may consider closing the trade for a loss if the loss gets too large.

In defined risk trades, the potential profit and loss are known at order entry when the position is established. They also benefit from a lower buying power requirement which usually translates to a higher Return On Capital (ROC). Management of these positions tends to be much more straightforward.

Our studies have shown that closing both undefined and defined risk trades at 50% of max profit is a logical move. Our general rule on taking a loss on an undefined risk trade, such as a short put, is when the loss is twice the maximum potential profit.

Would applying the same rule to a defined risk trade be logical? With defined risk trades, the worst-case scenario is known. When selling vertical spreads we generally try to collect a minimum of one-third the width of the spread. This means that a loss equal to twice the credit received would bring us to the maximum loss of the spread. Closing a trade for a maximum loss doesn't make sense since the trade can't get any worse.

Watch this segment of “Options Jive” with Tom Preston (TP) and Tony Battista for the valuable takeaways and a better understanding of how to manage defined risk trades.