Saturday, February 21, 2009

How Long Will My Trade Be?

Recently, a subscriber to the Option Trader service wrote to ask why I bought LEAPS (that expire a year to three years out) when I only planned to be in a trade from 1 to 3 months. That is definitely a great question that raises what I consider to be some very important issues about all trading, whether stock or options.

The first answer with regard to my own trading is that I do not employ an exit strategy based upon how long I plan to be in a trade. In other words, when I enter a position, the length of time is not going to be the reason for my exit (unless, of course, it is an option that expires). I try to remain in a position depending upon the price behavior of the stock. Why, for example, would I want to exit a bullish position when the stock is continuing to move up? That action would serve to cut my profits and that is something I want to avoid. Similarly, if a position turns against me, I want to get out. I want to cut my losses and let my profits run.

Unfortunately, and all too often, investors have no exit strategy. Witness so many in the most recent bear market who have seen their portfolios drop 40% or 50% or more. Many times they remain in positions because they are "investing for the long term." Sadly, that has not worked for those holding stock in companies like Enron, Lehman Brothers, Bear Stearns, or Washington Mutual. An exit strategy that is only defined by time can result in some very serious losses.

Instead of defining my exit strategy solely by time, I try to use a specific discipline that I pre-determine before I enter the trade. I might use a break through a moving average or a break through a trend or the crossover of two moving averages. The choice can vary from play to play, but it is based on some discipline other than the passage of time.

Specifically relating to the subscribers question, when I buy call options, I buy a lot of time. Generally, if I remain in the position it is either because the stock price is continuing to move up or because I want to use the position as an underlying against which I can bring in income by selling other options. Additionally, buying long term options or LEAPS (technically Long Term Equity Anticipation Securities) the time decay portion of the premium initially does not run against me as quickly and I often can find a better delta than I would at the same strike price with a nearer term expiration.

I would add one thought and that is some successful traders do use a time stop to exit positions quickly if the play does not begin to run in their favor relatively quickly. For example, even if I were using a price support as an exit, I may have decided in advance to exit my position if the stock doesn't move my way within 2 or 3 days.

Bottom line, for me, is to let the stock price movement make the decision for me when to get out rather than to use a purely time-based exit.

by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved

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Anonymous said...

Dear Bill:
It's good to see this info in print.
I learned the hard way. We beginners
have expensive lessons. Thanks for
the heads up!!


Anonymous said...

Dear Bill: I, too love to buy options with long expiration dates. But when I sell options ( as I have been doing since reading your book Trade Your Way To Wealth, which was very helpful in showing low risk trades) I like selling covered options with less time on them, even if the premium is a bit smaller. Sincerely, E. Stein

robcanavan said...

go small in a index that trades thin then dollar cost average on entry ..exit on rally or sell off ( long or short )..and you will be able to trade in and out and never take a stop loss..

Bill Kraft, said...

Hi Kath. Thanks for writing. Hope it helps.
Bill Kraft

Bill Kraft, said...

E Stein, I agree completely. As a general principle, when I am buying options I buy a lot of time (though I very well may not hold them until anywhere near expiration). When I sell options, I ordinarily look at selling short term out of the money options. Since the time value deteriorates very quickly with little time to expiration, and I have sold only time value, I believe it often can be helpful. Thanks for writing and thank you for the kind words about "Trade Your Way to Wealth."
Bill Kraft

Anonymous said...

Please terminate my subscription to "Success Trading Group"

James F. Ward
3713 Galloway Lane
Carrollton Texas 75007