Option Survival: Setting and Following Bailout Levels
Summary:
Options traders face a dilemma: When should you close out a position and take your profits or cut your losses?
If you do not have a specific goal or bailout point in mind, this question is a difficult one to answer. It comes down to the possibility that without the goal, there is no “right time” to close out the position.
This programs traders to lose most of the time. An alternative that makes a lot of sense is to pre-set policies identifying the exact profit and loss levels where positions will be closed. The second part of this idea is self-discipline. You have to decide to follow your own rules and to resist any doubts that arise based on how option values change.
Definitions:
A profit goal is the percentage or dollar value that serves as a predetermined trigger to close a position. For a long position, the profit goal is an increment above the net basis. For a short position, it is a level of decline in value, at which a “buy to close” order is entered.
A bailout level is the maximum loss you are willing to accept. Once that level is reached. the position is closed to avoid further losses. For a long position, this is a percentage or dollar amount below the original cost. For a short position, this is an increase above the original short value. Upon reaching a short basil-out level, the position is either closed at a loss or rolled forward.
Rules:
Options traders are wise to decide in advance at what level they will close existing positions. This applies to long and short positions equally. For example, a profit goal for a long position may consist of a dollar value or a percentage. The rule might be to double the original investment, or to gain $200. Once that goal is met, the position should be closed and profits taken.
The profit goal for a short position may be based on the same criteria, either a percentage or dollar value. For example, a seller may decide to close a position if and when the value falls to one-half of the original sales amount.
On the loss side, the purpose is to set a bailout level. This may be a percentage of the original basis or a dollar value just like the goal set for long positions.
The key point to remember is that without these profit and loss triggers, you have to way to decide when to close positions and take either profits or losses.
The programmed loss approach
The lack of specific profit goals or bailout targets could mean that your options trading is programmed to always lose. For example, if you open a long call position and its value declines, you may decide you must keep the position open until the value rises to your starting point. However, once that starting point is reached, the next trap is deciding that the option’s premium will continue up — so no action is taken. In fact, even if it does rise, you fear closing it out because you think it is going to rise farther.
If the option value rises after your purchase, you cannot sell because you believe it will continue rising, even though this defies logic. Time decay invariably offsets appreciated value. Even so, some traders simply do not close out profitable positions. When value does decline, another destructive inner voice tells you to hold on until the value again reaches the high point it previously held.
All of these games that option traders play. When do you take profits or cut losses? Without clear rules that you set for yourself there is no clear price level where a sale makes sense.
The same problem applies to sellers. For example, if you sell a covered call and its value rises, do you roll forward, accept exercise, or take no action? If the premium of the short call declines, do you wait it out and let it expire, or close at a profit? If you have not decided yet when to close out the short position or roll it forward, then it’s all a guessing game. Profits become less likely the longer this continues.
A basic exit strategy
You are more likely to increase profits and minimize losses when you set (and follow) rules for when you will close an option position. For example, if you buy an option, you might define your time to sell in the following way:
The premium value doubles; or
The premium value is reduced by half.
This is only one example of a simple rule you can set. For example, if you buy an option for 3 ($300), you will sell if it increases to 6 ($600) or when it declines in value to 1.50 ($150). You may also make these rules applicable on a pre-brokerage fee basis or a post-brokerage fee basis.
Another example: You may decide with a long position to sell based on changes in dollar value. For example, you will sell if and when:
The premium value nets an increase of $100 or more; or
The premium value falls by $100 or more.
This works for any long position. For short selling, the decision is the same based on either percentage change or dollar value change. For example, if you open a covered call, you may decide to buy to close when:
The premium value declines by one-half; or
When the option is at or in the money.
You can apply dollar values to this as well. For example, you may tell yourself you will close the covered call when its premium value has declined by $100. With short positions, you also need to determine if and when to roll the position forward. You can take this action when the short call approaches the money or actually goes in the money; or you can make the decision based on the position being in the money and within one to two weeks of expiration.
All of these proposed rules are only examples. Every trader needs to develop a specific set of standards to identify the point of exit. Without these, you are sure to realize more losses than profits.
Michael C. Thomsett is author of over 70 books in the areas of real estate, stock market investment, and business management. His latest book is The Options Trading Body of Knowledge: The Definitive Source for Information About the Options Industry. Thomsett’s other best-selling books have sold over one million copies in total. These are Getting Started in Options, The Mathematics of Investing, and Getting Started in Real Estate Investing (John Wiley & Sons), Builders Guide to Accounting (Craftsman), How to Buy a House, Condo or Co-Op (Consumer Reports Books), and Little Black Book of Business Meetings (Amacom). Thomsett’s website is www.MichaelThomsett.com. He lives in Nashville, Tennessee and writes fulltime.