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Over the past couple of months, the market has been challenging…
Promising rallies have reversed on a dime. Likewise, 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, it can be a frustrating time to trade. 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.
And 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 for the move 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…
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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. They will make things far clearer:
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Does the rationale or thesis behind the trade still stand up?
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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.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
P.S. The market can change quickly… That’s why I want to start sharing my trading ideas live throughout the week – as a free benefit for readers of Trading With Larry Benedict.
My goal is to make The Opportunistic Trader your best resource for trading knowledge and insights. And I think this new project will be an important step toward meeting that goal.
As I’ve said, stay tuned for more details in the coming days…