Buying and Selling Options: You see the breakout, or you see a pre-split stock start to move up. You place your order to buy options, you receive confirmation you were hit, and things look good. Then, bad news hits the market, and stocks drop. Not a huge selloff, but the rally softens. Your options that cost you $12 a pop go from being up a point or two to being down $2 in an hour. What do you do?
That question is impossible to answer in a general discussion. There are too many variables that impact any particular option, including news on the underlying stock, volatility of the underlying stock, market conditions, etc. There are, however, some rules that you have to set yourself on any option trade.
Options are a wasting asset, and the closer to expiration you are, the quicker they waste. Many other factors affect an option’s price, but time is a big one. Thus, time until expiration is always a critical factor. In the last thirty days, the time decay on an option increases faster and faster. If an option is out of the money, the decay can be even faster. If you are two weeks from expiration and the underlying stock is falling, your option price is going to really start to decline. It would take a major turn around to get back to even. In that event, we would seriously consider getting out of the position with what we have. One general rule we have developed is that if our options get down to 50% of what we paid for them, we sell. That is a very general rule, but think about it. We have ridden options down to zero hoping we would get that turn around. In some rare cases, the miracle happens. Usually it doesn’t. We would love to have 50% of the cost of those options back.
We play many volatile stocks. Accordingly, the options are volatile as well. If things do not go right in a play, i.e., the breakout fails, the pre-split peaks early, the pre-announcement does not come through and the stock falls, we usually get out pretty fast. We do a quick analysis of the situation and decide if we stick or sell. We usually buy a lot of time on our plays (other than pre-splits), and that gives us some luxury to decide if we stick or hold. If the stock is performing well overall and the fall can be easily explained and is not fatal, we may decide to stick it out. In a rallying market that can often work to your advantage. If you don’t have the time, your choices are greatly limited, and your hand is more or less forced. In that case, your best bet is to get out with what you can and move on. If you have to swallow a frog, it is best not to look at it too long before you do.
