How to Know When to Take a Loss

Larry’s Note: Forbes is calling it an “IPO tsunami.” Fortune says the floodgates are open. And the recent SpaceX IPO was only the beginning.

Because more than 800 companies are lined up to go public right now. And it’s about to make a lot of Wall Street insiders very, very rich.

Meanwhile, everyday investors will watch from the sidelines… locked out and left in the dust again. The game was rigged long before they ever heard any of these companies’ names.

That’s why I’ve perfected a low-stress strategy for pocketing $321, $1,605, or even $3,210 or more on IPO days. It all comes down to one simple, five-minute trade you can make from your phone the morning a company goes public.

And this Wednesday, July 15, at 8 p.m. ET, I’m walking you through the entire strategy. If you’d like to join me, simply add your name to the guest list with one click right here.

Sometimes, the market can be challenging…

Promising rallies reverse on a dime. Or just as selling reaches a fever pitch, the market snaps higher. Profitable trades turn into losers.

Even if you have a clear entry and exit strategy, trading can be frustrating. You can get stopped out of a trade… only for the stock to recover back to your entry price.

As annoying as that can be, you still have to stick with your stop losses. Risk management is a must if you’re going to survive as a trader over the long term.

But while it’s usually simple to set a stop loss on a stock trade, it’s not always so clear how to do so with options.

So today, I want to discuss how I manage cutting losses for option trades…

Limited Time

One of the major differences between stocks and options is that options expire.

Their value erodes as you get nearer to that expiration date. Vitally, this “time decay” accelerates the closer it gets to the option’s expiration. And that has a profound effect on how you manage an option trade.

Put simply, you don’t have the luxury of endless amounts of time…

Each day that the anticipated move doesn’t happen, you’re giving up a growing portion of the option’s value.

To help counter this effect, I typically buy an option with an expiration at least a couple of months out. It gives the trade time to play out.

It also helps avoid the worst of time decay. All else being equal, an option loses roughly two-thirds of its value in the second half of its life. It’s this characteristic that we want to avoid.

Ideally, we’re in and out of the trade anywhere from a day or two… up to a couple of weeks.

So time is a key factor in determining when to exit a trade.

However, there’s one more element to consider…

When to Move On

You usually buy an option because you believe that a move up or down is imminent.

Buying an option in the hope of a move playing out “sometime in the next few months” is often not going to cut it.

So a critical part of deciding to exit an option trade is conviction in the trade – or lack thereof.

For example, say I buy a call option in anticipation of a stock rallying from a key level. If that level doesn’t hold and the stock falls, I’ll often look to exit the trade.

Likewise, if I buy a put option, thinking that an overbought stock will pull back, I’d look to exit if the stock keeps rallying through key levels.

To be clear, I don’t necessarily bail out of a trade right away. If we buy options with a couple of months to expiry, we have some leeway.

But the moment I no longer trust the original thesis behind the trade, it’s time to exit. The trade has gone stale, and it’s time to move on.

So when you’re trying to decide whether to exit an option position, consider these two questions to make things far clearer:

1. Does the rationale or thesis behind the trade still stand up?
2. Is time decay eating too much of the option’s value?

If these factors no longer work in your trade’s favor, then it’s time to exit and move on to the next trade.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict