Invest and Trade Profitably with Jon Johnson

When trading options, when should one cut losses and bail out?

August 30, 2000

Love the questions that seem simple, but are not. Unlike trading stocks, trading options has the time element to consider. An option loses most of its value in the last thirty days before expiration. If a stock is not performing as planned and you have three months until expiration, you can ride through some down time if the stock is not breaking down technically. If the market looks weak or the stock starts changing its trend or pattern, we consider getting out before any real damage is done. We do not have a general stop price we use as different options have different deltas, open interests, and stocks with different volatilities. Basically, if the stock does not do what we thought it would do after we make our entry point, we get out pretty darn fast. We can always get back in, and we have the money to do it.

If you are running out of time, i.e., entering into the expiration month and the stock has a long way to go to recover or is falling, we prefer to cut out and preserve what we have to fight again when things improve. Remember, when you enter that last 30 days, the option starts to lose value at a faster pace. Your stock can be moving up, but if it is not really making a solid move, your option can just hold its value or even decrease in value as the stock moves up-now that is frustrating. In that situation, we carefully evaluate whether we think the stock will make a solid move. We may be better off taking our money off the table and buying more time if the think the stock is going to make a good move.

Let’s say the worst happens. You have an option position and then the market drops and you didn’t have stops in or you could not place stops on that option and the market sells off-like this week. You have April options. That means that after Friday you are entering expiration month. Your options have lost a significant portion of their value already. Do you wait for a miracle or get out? If you have potentially market-moving news and things look ripe for a rally (sound familiar), maybe you will get a move up or a rally starting that will bail you out. That has happened to us before. It is great when it happens, but it doesn’t always happen.

What we do in that situation is cut our losses at 50% if the stock continues to fall and the option is at that level or lower. We don’t want to take less than half our money home if we can. Again, that gives us another day to fight. Think about it. Wouldn’t you like to have 50% of all the option money you ever lost?

We have some ‘iffy’ positions that we are holding to see what the economic news brings. We have what we feel is a strong chance for a rally, so we are looking to recover some lost ground and make some money. If we don’t get the moves we want after the CPI numbers, however, we will most likely take the money off the table.

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