Credit: Shutterstock photoOptions traders and stock buyers are alike in one respect: both make their buy and sell decisions based on their expectations for the stock within the parameters of their individual risk tolerance.
Options traders, however, have an additional consideration: when to get out of a trade. This decision can be made much easier with proper planning ahead of opening the trade. One key guideline that many traders adhere to is letting profits run while cutting losses short.
Since options traders will invariably have more losing trades that winning trades, the key to success in options trading is putting this philosophy into practice. The way to achieve solid profits while limiting losses is through the disciplined use of targets and stop-losses .
To maximize your winnings, shoot for substantial yet achievable profits. While an 800% profit would be great, it's probably not achievable. On the other hand, a 50% gain is easier to pull off, but probably not substantial enough to outweigh your losses. Depending on the strategy, a more practical target for an options position may be 100%, for example. This is a reasonable and achievable profit that is large enough to more than offset your losing trades.
While it's important to let your profits run, it's vital to approach this in a disciplined manner . For example, if a position has reached its target profit of 100%, an investor may choose to raise his target to 125%, feeling that the drivers underlying the trade are still intact.
However, if the option begins to lose ground after the target is readjusted, the investor should close out the position once it falls back to the 100% profit level. To succeed in options trading, it's best to stick to this disciplined method and not take profits haphazardly.
Controlling your losses is one of the most important components of successful options trading. Your goal is not to avoid them, but to keep them as small as possible by taking your position off the table early.
Remember that time is the enemy of the options trader! Stockholders have the luxury of time to wait out trades that initially move against them, but options traders don't. You don't have to close out a position as soon as it moves a few ticks against you, but you should begin to reexamine the validity of the trade.
To help keep your losses under control, you should make judicious use of both price and time stops .
First, you should decide the level of losses that is unacceptable to you, and close the position when it reaches that level. We often recommend closing out positions before your losses exceed 50%. It just doesn't make sense to hold on to a trade that requires a double merely to break even.
Second, you should determine a maximum holding period for the trade and close the position under any circumstances when that time period has expired. For example, if you set a one-month holding period for a three-month option, close the position after one month. Remember, even if the stock hasn't moved sharply against you, the value of your option continues to erode due to time decay. If the underlying equity hasn't moved quickly in the right direction, cut your losses and the potential for continued time decay by closing the position after a pre-determined time period.
These tips on taking profits and limiting losses should help make the decision-making process of when to close out an option position much easier. Remember, the key to successful trading is setting profit target and stop-loss limits ahead of opening the trade.
Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
