Option Investor
Educational Article

Exit Strategies, Escaping with Profits

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No, this is not an article on Sell Too Soon. I just wanted to put all your minds at ease that I was not going to try to twist your arm to sell those winners, while they were still winners.

I am going to try to broaden your horizons with some types of exits that will add to your profits and reduce your losses. With that aim, I have to build from a common base and move into the more exotic stuff. So bear with me.

STOP LOSSES

It would be really nice if we never needed to discuss this topic but we all know that Murphy's Law is alive and well. Before you enter a trade, you should always know how much you are willing to lose. I said LOSE. I know from experience that most will enter a $6 option with the idea that you will sell if it hits $10 or $4. Profit and loss. Now in reality the closer the price gets to either number human nature takes over and we start changing the plan. On the loss side, the closer it gets to $4 the more you will start rationalizing that the stock chart looks like a bottom is forming. I will sell it when it gets to $3.00. It had to be just a large block order. The drop is market related. I will sell it when it gets to $2.50. The earnings's warning was from another company. It will bounce soon. I will sell it when it gets to $2.00. It has to come back up. I will sell it when it gets to $1.00. Why did the jobs report impact my stock. I wish it would go back up so I could get $1.00 for it.

Lose means sell for a loss. Not hold for a loss. Before a $6 option can sell for $2 it has to sell for $5, and $4 etc. The trend is going against you and yet for some reason we always convince ourselves that it is just temporary. Once you understand the following principle and act on it, selling for a loss will be a lot easier. Here is the principle: You can buy it back.

When you are in the trade you cannot think clearly and objectively. Maybe you are that one individual that can always do this but I have never met anyone that does. We all know that when a trade is going against us, the minute we sell for a loss is the minute the stock will rebound like a rocket. This keeps us from exercising rational judgement and closing the trade. In reality this is always made worse by our procrastination to sell in the first place. If we had sold that option at $4.50, we would not have had the problem of rationalizing a sell for a bigger loss at $3.

If we are in a trade and we researched every conceivable way before making the trade and the trade goes against us then the answer that should instantly pop into our minds is:

OOPS! That was not the entry point! I will sell it and wait for a better entry point.

If we had that attitude then everything else in trading would be easy. Instead, we all take the position that "It will come back" and our fate is sealed. We agonize over every .25 drop in the stock and corresponding drop in the option. We are totally focused on this position and are missing other winning plays because we are trying to "hope it back up."

Think about it. If you liked the stock/option at $6.00 you should really like it at $2.00. If you had sold it at $4.00 and the stock was bouncing then you would love to be back in at $2.00.

The essential point here is the decision you make to get back in. If you had not made the first trade, WOULD YOU BUY THIS OPTION ON THIS STOCK AT THIS TIME AT THIS PRICE?

This should be an entirely different decision. Not one based on a previous play. Many times traders will jump right back into the fire they just escaped from simply because they felt the first loss was just a mistake. MAKE SURE THE SECOND BUY IS BASED ON SOUND REASONS.

Types of stop losses:

When you enter the first trade, you should know exactly where your loss exit will be. This number can either be based on the option price or the stock price. There are pros and cons to both. Basically, the option price is loosely tied to the stock price. Depending on the time remaining and the ITM/OTM depth of the strike price the option price can move more OR less than the stock price.

Stops based on Option Price:

By setting a stop loss based on the option price you are not filled until the option price actually hits that price. Sometimes the stock can be moving so fast that the option price lags the actual stock move. By the time the option prices hits your stop and then you get executed it could be much lower than you expected. When stocks are moving rapidly the spread between bid and ask on options widens.

Stops based on the Stock Price:

Recently another way of setting stop losses has been developed. That is setting the stop loss or sell order based on the stock price. I believe this way has merits for many situations. If you are setting stops that are very close to the current option price then you should use the option price method. Let's say you bought a $6 option that is trading for $10 and you want to set a profit stop loss at $9.50. When the bid hits $9.50 your order turns into a market order instantly and you execute at or close to $9.50. Stops based on the stock price are better utilized as catastrophe insurance. If your $6 option was trading at $10 and you wanted to protect yourself against intraday spikes in the option price due to order volume or small swings in the stock price then you could use a stock price stop. If the stock price was $150 you could enter the order to sell your option if the stock price touches $144.75. It would take a full $5.25 downward move in the stock price to execute your sell but you would be protected against a major disaster. The example is extreme but I think you get the idea. I like the stock price concept since the stock price is what drives the option price. If some event caused a quick drop in the stock price your order could be executed before the option price had a chance to fully equalize and possibly get you out quicker and for a higher sell. The only broker I know that offers this option is Preferred Capital.

Trailing Stops:

A wise way to use stop losses is to follow your option price upward with a trailing stop loss. This prevents you from losing all the profits you have gained to that point. If your $6 option is now trading for $10, and you would rather not take the 66% profit then set a stop loss for $7.75. I never use an even number. If you watch the bid and ask on active stocks like QCOM or JDSU then you will see the market maker adjust the bid from a 1/4 or 3/8 to 13/16 or 15/16. He will not go to the even number. Retail investors tend to set even numbers as limit sell stops and by stopping the bid on the even dollar number he will get a flood of sell orders. By setting the bid, just under the even dollar amounts he has time to survey the order flow and decide where to go next. Options market makers however seem to like even numbers. If the stock is falling they will tend to react to the next even number for the option price. Setting your trailing stop at the $x.75 level may keep you from being stopped out by an intraday spike. It has saved me on numerous occasions.

Selling for a Profit:

Now that we got the stop loss discussion out of the way, we can move into the more enjoyable side of selling. Selling for a profit.

There are many ways to do this but first consider trailing stops as your first line of defense.

The best offense is a limit sell for a predetermined amount. If you are happy with a 66% profit then place a $9.88 limit sell for your $6.00 option once your order is executed. You will have a much better chance of being filled if you use the same logic on profit sell orders as you do on stop losses. That is don't place even number orders. The best number is probably $x.75. It allows the market maker to set the ask for the even number and then creep the bid to take you out at the same time. Obviously you need to take into account the normal bid/ask spread on the option first. If you are playing QCOM options the bid/ask spread could be $2 but an AOL spread could be only 1/8.

Once you set your limit sell you can become the market at any time. If the stock moves quickly and the order flow is thin then the market maker may not want to cover you and the next "market" buy order that comes in can take you out even when the posted prices are different. This should not happen in an electronic market but it does. Whenever humans are involved human nature plays a big part in execution.

Set a sell immediately after you buy!

What to sell for?

I will not go into the different rationales for when to sell but you know my thoughts. I like to take a profit over and over instead of trying to make a homerun on every play. I feel like the longer you have an open position the more chances of a market event turning your profit into a loss. With a $10,000 account, if you took a 25% profit once every two weeks for a year you would have $62,500 profit without the benefits of compounding. Read that again. If you never invested more than $10,000 total at one time, and only closed the trade once every two weeks, you could make over $62,500 in one year. Granted, some positions will lose money but even if you are in the market you will also have many positions that will make more than 25% due to news events or gap opens. I estimate that a trader who will follow instructions EXACTLY can net $50,000 on a $10,000 account every year without fail. Notice I said follows instructions EXACTLY.

Different personalities of course will want to risk larger losses for the possibilities of larger profits. That is your choice. Just don't bad mouth options trading if you get your account cleaned from time to time.

Types of Closes:

The simple way out is of course to sell your entire position at once when your profit target is reached. Too simple? Too limiting? Not enough upside? Not everyone likes coffee either.

Optional exits include selling only a portion of your position at predetermined exits. This allows for greater profits on the remaining contracts while locking in a minimal return on the early contracts. Lets say you bought 20 contracts at $4.00 and sold 5 contracts at +50%, 5 contracts at +75%, 5 contracts at +100% and 5 contracts at +150%. Your total profit would be 7,500 and you would have only $1,500 at risk after the first ten contracts are sold.

20 x $4.00 = $8,000
5 x $6.00 = $3,000 50%
5 x $7.00 = $3,500 75%
5 x $8.00 = $4,000 100%
5 x $10.00= $5,000 150%

You can adjust this scenario any way you want. Maybe 10 @ 50% and 10 @ 100%. The downside of course is the length of time in the trade. The first sell may be in only a day or two and the last sell could be two weeks later. My thoughts are always on limiting my time in a trade. The longer you are at risk the better chance of that risk biting you. Of course my trading goals and risk profile is much shorter than 90% of most option traders. If you are committed to holding options rather than trading them then this is a good strategy for reducing your risk. After the first half sell, the trade is almost risk free and you can ride it indefinitely.

Now the exciting exits!

Exiting on the upside

Lets say you have been in a play for some time. Your $6 call option for the $75 strike is now worth $13 and the stock is at $86. You could just sell for the $13 and have a homerun but you feel that even though the stock is looking tired it may still have some room to move. How can you maximize this position?

Consider this. Sell the $90 call option to close the play. If the stock is at $86 the $90 option is probably $5 or more depending on the time remaining on the option. By selling a higher priced strike you lower your cost on the play. If you sell the $90 for $5 your $6 option now has a cost basis of $1.00. If the stock finishes under $90 your higher strike expires worthless and you keep the $5.00. If the stock goes over $90 your upside on the $75 call is now limited to $15 (the difference between $75-$90) but you made $5 on the higher call. At expiration you exercise your $75 call to cover the $90 call you sold. The net to you is $20. This type of play should be used on tired stocks that may have peaked and you expect them to finish around the strike price you sold. The risk is having to hold the $75 call longer to remain covered on the $90 call. Of course, you could close both positions at any time the stock price started falling. You should still be profitable on both since the OTM $90 call will decay faster than the ITM call.

Exiting on the downside

Yes, it happens. You did not sell when it hit your stop loss. Now you are wishing you had sold but the stock just does not want to cooperate. Your $75 call for $6 is now only worth $.50 and the stock price is $72 and dropping. How can you salvage some capital?

Consider this: Sell the $70 call for $3.00 using your worthless $75 call for collateral (margin). If the stock price is $72 but sliding then the ITM call for $3.00 is soon to be out of the money and worthless also. You recover $3 of your investment in the $75 call. If the stock continues to less than $70 then both options will expire worthless and you keep the $3 or half of your starting investment. Your risk is that the stock will have a miraculous recovery and bounce off $70 and move up again. This is good news! You should close the position on the call you sold when it passes what you received for it. The good news is that your previously worthless call is now appreciating in value and the play you started with is alive again. If you did not cover in time the most you could be out is $2.00 even if the stock went to $100. That is the difference between $70 and $75 ($5) minus the $3 you received as premium. The way to avoid this is to maintain a buy to close stop loss of say $4.00. Your total out of pocket would be $1.00 and you are still long an appreciating $75 option.

Conclusion:

It is always better to manage profitable positions than losing positions. Be proactive on the profit side and totally inflexible on the down side. Set your stops and take small losses.

Jim Brown
Editor

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