Everyone wants to know where to make the most money in the shortest amount of time. Sometimes, however, it’s just as important to know where you aren’t going to make the fast money — and right now, at least, it’s tough to make money by owning common stock.
The cardinal sin of investing, which is particularly atrocious when it comes to options trading, is letting big profits slip away.
Let’s face it, one of the main reasons we trade options is for their home run potential. With options, you are essentially swinging for the fences every time you step up to the plate.
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Like any good power hitter, you are going to strike out more often than you hit that home run — that’s just part of the game. But when you do knock it out of the park, it’s simply unforgivable to let that profit evaporate into thin air.
But how do you make sure you keep those home run profits when you hit them? Fortunately, the answer is quite simple in theory, although it’s not always easy to execute.
Stop the Madness
Making sure you keep the profits you’ve gained is really as simple as setting a stop loss. By developing appropriate stop-loss levels on all of your positions, you can protect the gains you have by not letting them slip through your fingers.
While you can set a stop-loss order with your broker to be triggered when an option hits a certain price, you can also keep track of the trade manually and set mental sell stops based on how the stock is trading. By doing so you won’t be taken out of the options trade unexpectedly, and you can exert more control by watching the stock closely and revising your trading strategy frequently.
Once you have a good profit, you should always set a trailing stop for the underlying stock — that is, a level just below the current market price. A 3% stop loss is a good rule of thumb. In other words, if the underlying stock’s price is $50, set a stop loss of $47.50. If the stock price hits $47.50, take profits on the rest of your option position.
Sometimes a tighter stop loss may be appropriate, but it’s important to be aggressive when you’re taking profits. People often ask me what really constitutes a “good profit.” The exact level is, of course, up to you to decide, but I consider anything in the double-digit percentages to be gains worthy of protection.
The trailing stop is tremendously effective when the trade is moving in your favor as well. If the stock trades up to $50 and keeps on going, ratchet up your stops accordingly, keeping them 3% to 5% away from the present stock price. That way, if the stock trades down from that higher level, you will have plenty of time to close the position and keep most of your profits.
However, even if the stop is not hit, you may still exit a position if you think the underlying stock is flattening out or when you believe it has hit some overhead resistance (for call option position) or underlying support (for put positions). That’s the beauty of options trading — you always have, well, options!
That being said, I can’t emphasize enough how important quick action is when things start turning against you. With options, due to their limited lifespan, you are usually only given one chance to get out. Given the time considerations, it’s essential that stop losses be in place and ready to protect your gains.
Beating the Clock
As I always say, for option buyers, time is your greatest enemy. Given enough time, most stocks will make a major move, giving you the opportunity to score a home run. If you can find an undervalued option with a lot of time left until expiration, you are looking at an opportunity that could turn into a terrific investment.
Always keep in mind that cheap, long-term options where the strike price is in range of the underlying stock price are truly diamonds in the rough. The point to remember here is to buy enough time for the option to work in your favor, because time tends to fly away.
Options depreciate as time passes, especially in the six-month period preceding expiration when they lose their value even more quickly. So, the following bears repeating: Buy yourself enough time. Also, always set a time limit on how long you will hold an option. If nothing happens within that time period, exit the position and rotate your investment capital to where it will perform better for you. With more-expensive options and in-the-money options, I usually set a three-week holding period.
Remember, you’re never stuck with an options position. If a position isn’t working out in your favor, it can easily be replaced. And if it is working for you, make sure you set a trailing stop loss so that you don’t let your home run trades slip away.
Bryan Perry is the editor of Tactical Trader, an options trading advisory newsletter, and is a contributor to the Options Zone Web site.