(By Michael Shulman)
Knowing when to exit an options trade is the most-difficult part of trading options, according to an OptionsZone survey. But after several years of managing my shorting service and 25 years of trading options, I have some rules.
These rules apply to options trades that are based on fundamentals -- i.e., whether a company is great or stinks, the stock will follow -- not on technical trading systems. If you are a purely technical trader, well, read this anyway.
My approach is best summed up by the poet -- actually the country western singer -- Kenny Rogers. His four rules for managing a position: "You got to know when to hold 'em, know when to fold 'em, know when to walk away, know when to run."
Don't gamble away your profits. Keep reading to learn my options exit strategy.
When to Hold 'em
If an options trade has made a big move up or down, or if the position is making you uncomfortable, how do you know when you should hold 'em?
You should hold when the components of the story that originally drove you to take the position are still in place.
For example, say you bought a put based on fundamentals, but the position isn't working out just yet. However, the company is weakening, the stock is in a stagnant or downward technical pattern, the market segment it is in is not running up and you are ahead of Wall Street in your view of the company. If the fundamentals are still in place, then you should stick with your position.
This is easier said than done depending on your level of experience and your nerves. But since I've had positions down 80% return gains of more than 100%, I know that, in the long run, this kind of discipline works very well.
When to Fold 'em
You fold 'em when the story that drove you to take the position in the first placed has changed.
For example, if you buy a put option on a lousy company, but it becomes an acquisition target, earnings are much better than expected, or some other fundamental part of the story changes, you should consider cutting your losses.
When to Walk Away
You should walk away when you have profits or are nearing losses that are more important to your portfolio than they were when you first set up the trade. Yes, your portfolio, your account, your cash money. Trades do not float existentially in financial space -- they are part of your investment portfolio, which is part of your wealth, and that, in turn, is part of your life.
I rode a private Internet company into being a publicly held company, had a fortune on paper, lost sight of my financial goals and stuck with the stock. If I had thought more about my life, I would have cashed out and retired. Since you are reading this, I am clearly still working.
When to Run
When I enter a trade, my goal is a double (at least). So when I get near or hit the 100% mark in profits on a position, I put on my running shoes and decide to do one of three things: take profits, roll the position or press the position.
One reason to run is when market sentiment turns dramatically against you. For example, if you have a put that has six weeks before expiration and a competitor to the company you have shorted reports great results, the entire segment could explode upward. If you don't see this momentum changing in the time left before your put expires, you run. Don't walk, run.
Rolling a position means closing the existing position, taking your profits off the table and re-investing the original capital in an option on the same stock that has a different strike price and/or expiration. The idea is to gain more leverage and an opportunity for another double.
Pressing means to close the position, and then take your initial investment plus your profits and put it back into the same trade.
I never use sell stops. I find options too volatile when you are investing based on fundamental and unfolding strength or weakness in a company.
However, I do recommend that people consider using a trailing sell stop when they have a large profit in a position.
Averaging down is tempting, and many traders do this successfully, but I am against it.
I think of it as throwing good money after bad. I would rather close a position and move on than commit more money to a losing trade.
When a position is working, why not put more money to work if the fundamental story -- i.e., your reason for entering that particular trade -- is playing out nicely?
Go for it.
The Secret to Survivin'
"Now every gambler knows that the secret to surviving is knowin' what to throw away and knowing what to keep."
Deciding when to close an options trade is no easy task.
Options may be a gamble, but the great thing about them is that the most you can lose is what you put in. So keep the iconic words of Kenny Rogers in mind and take an active role in managing your options positions.