- Investors face a number of challenges and decisions along their journey to profits.
Ask option traders about their biggest challenges, and you’d think deciding when to enter a trade would be No. 1.
Well, OptionsZone.com surveyed more than 1,100 investors (see the results) about a variety of topics, including which factors are most difficult when it comes to trading options.
Guess what they said?
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Get Me Out Of this Trade With a Profit
Yes, deciding when to exit an options trade is the most difficult part of trading options, according to OptionsZone readers. The most common answer, grabbing 46% of the responses, was a clear cry for help with getting out of a trade.
Surprised? We aren’t. Closing trades can be stressful. So we thought we’d provide three basic strategies for determining timely exits for your option positions. The good thing about these guidelines is that they are so simple that everyone can apply them to their trading.
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Use Technicals
Common tools used by traders to identify optimal entry prices for a stock position are the various levels of support and resistance arising from the technical analysis of a stock. The same applies to closeouts. We usually keep an eye on the significant technicals of the underlying asset to identify timely exits for our option positions.
We’ll use a return to a significant support level as a signal to close out a put, because that indicates that the stock may be due for a short-term bounce.
Or we may close a call as the underlying asset approaches significant resistance in the form of a declining moving average.
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Dollar Tree (DLTR) Exit Plan
On Feb. 6, we recommended buying calls on Dollar Tree (DLTR) following a sell-off in the stock after earnings. At that time, we identified $41.50 — the location of the stock’s 50-day moving average — as a potential exit point for our option position. Reviewing the chart, DLTR had been extremely reactive to its 50-day moving average as a catalyst for support and resistance.
Following this approach, we issued a sell recommendation to our Winning Edge subscribers on March 4, when the stock ran into its 50-day trendline, which had declined to just below the $40 level. The results? Our option position returned a 61% profit.
Could the stock have moved higher, resulting in a better return? Of course. But for our purposes — and our subscribers’ collective sanity — we followed the technical approach for exiting as it provided a logical, reasonable and profitable closeout.
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Eye a Profit Target
Our second approach is simple and straightforward: Set a profit target as you enter the trade and stick to it. Period. Just as you wouldn’t set out on a long trip without setting a destination, you shouldn’t “throw” an option position on without setting specific profit and stop-loss targets.
And then, most importantly, follow them! That way you avoid one of the common pitfalls of trading, especially when you have a profitable trade — GREED.
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Setting Price Targets
So, how do you set these targets? Typically, we set a target price for the underlying stock and then calculate the potential option returns of such a move using an options pricing calculator (easily found online).
We generally operate in an environment where our upside, or profit, target is defined by a stock that will move enough to yield a 100% return (or more) on our option. This is one of the ways that we select our option for the trade (but that’s a discussion for another day).
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PowerShares QQQ Trust Trade Exit
In mid-February we identified the PowerShares QQQ Trust (QQQQ) as likely to see a significant drop. At that time, we identified the November lows as a target for the QQQQ decline. Based on this analysis, we recommended the March 30 Puts as a timely trade, given a presumed return of 100% on a drop to the November lows. Thus, our profit target of 100% was identified at the time of entry.
After some volatility in the market, this option position hit a return of 114% on March 5, triggering a closeout based on our target profit. This profit coincided with a drop in QQQQ to near its November low.
Could the puts return have gone higher? Sure. But in this case, given that the monthly employment report was set to hit the tape the next day, it added an unknown variable to the trade, so we decided to walk away with triple-digit profits.
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Watch the Events
Our third rule is a bit harder to implement: Watch the market for events that are likely to cause uncertain movements.
One of the most frustrating things in options trading is watching the market react to an event, dragging your option into the “red.” For this reason, we often try to avoid event trading, unless it provides us with an edge.
Events such as employment reports, GDP announcements, interest rate decisions, etc., are less predictable and can have a huge effect on individual stocks. So, we keep our eyes on upcoming events in the market and close positions to lock in profits before these announcements are due.
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QQQQ Put Trade Exit
The previous PowerShares QQQ Trust (QQQQ) put trade example illustrates our point.
While the trade had hit its target return, we were also concerned about the monthly employment report coming out the following morning. The previous reports had been negatively, and the market had lowered its expectations as each report passed.
This meant that the market could possibly rally, despite a poor report, which would have dropped our QQQQ position out of our target return range. We closed the position based on the upcoming event.
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Earnings Announcements
You’ll recall the caveat that I threw in about an event providing an edge. Let me explain. One of the underlying catalysts of many of our trades is earnings announcements. That’s clearly an event. But we view this particular event as an edge given that we do a large amount of due diligence and research on what the market is expecting for a particular earnings announcement.
Using this work, we take advantage of disparities between expectations and reality to tilt the market’s probabilities in our favor. See 12 Keys to Trading Earnings for Profits.
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Trading Exit Strategies
Remember to follow these easy-to-implement steps for closing an option position:
- Learn to read the technicals.
- Set profit targets.
- Watch for events.
Determining when to close your option positions should help to increase your effectiveness as a trader. Perhaps as important, it should help your sanity, especially in the current market environment.
