Risk management is drilled into us when we start trading. And for good reason…
If we let our emotions get the better of us, a dud trade can turn into a disaster. That’s why it’s always good to choose a predetermined point where you’ll exit a trade.
A stop loss on a stock or index is one good method, such as a fixed dollar amount or percentage where you’ll close a trade. But things aren’t always so clear when it comes to options.
With options, there are multiple other factors to consider.
So today, let’s check out how I manage option trades…
Accelerating Time Decay
One of the major differences between stocks and options is that options expire.
If an option expires without being exercised or sold, it ceases to have any value. So from the moment you enter an option trade, time starts eating away at the value of your option. We call this “time decay.”
Time decay accelerates the closer the option gets to expiration. And that has a profound effect on how you manage an option trade.
Put simply, you don’t have the luxury of endless time… Each day that goes by without the anticipated move coming to fruition, you’re giving up a growing portion of the option’s value.
To help counter these effects, I often buy an option with an expiration at least one to two months out. It gives the trade enough time for the anticipated 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. And that’s what we want to avoid.
Ideally, we’re in and out of an option trade in a couple of days to two or three weeks. That avoids the worst of time decay.
Avoiding the effects of too much time decay is key in determining when to exit.
However, there’s another element that also plays a part in managing an option trade…
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When to Move On
One of the reasons you buy an option is because you believe that an anticipated move is imminent. Otherwise, there’s little point in doing the trade.
So another reason I’ll decide to exit an option position is if I no longer have conviction in the trade…
For example, say I buy a call option in anticipation of a stock rallying off a key level. If that level doesn’t hold, then I’d look to exit the trade.
Likewise, say I bought a put option in anticipation of an overbought stock pulling back. If the position keeps rallying, I’d exit that put position.
To be clear, I wouldn’t necessarily exit these trades straight away. Since we typically buy options with a couple of months to expiry, that gives us some leeway.
But the moment I no longer have conviction in the thesis behind the trade, I know it’s time to exit. The trade has gone stale, and it’s time to move on.
Exiting an option trade might not seem as clear-cut as a stop loss on a regular stock. But by applying two tests, it will make things clearer…
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Does the rationale behind the trade still stand up?
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Are we at risk of time decay eating up too much of the option’s value?
If these factors no longer stack up, then it’s time to exit and move on to the next trade.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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