Most stock traders know the benefits of having a clear exit strategy
Having a fixed exit point before you enter a trade reduces the emotion and second-guessing.
When a stop loss or profit target level triggers, you’re straight out of the trade.
But when it comes to options, things aren’t always as clear.
So today, let’s look at how you can determine the best option exit strategy…
The Importance of Price and Time
When trading stocks, a common exit strategy is price. If a price level is hit, you close out your position.
The same can apply to options.
You can exit your position based on the underlying stock or the option price hitting a specific level.
For example, say you buy a call option in anticipation of a stock price hitting $150. You can close out the call option trade the moment the stock hits this target.
Alternatively, you can base your exit on the actual option price and take profits if the premium hits $12.
But for a stock trader, time is a flexible consideration. They have the luxury of having as much time as they need.
In contrast, options have a fixed expiration date, so time is always a factor.
If the planned move doesn’t happen in your expected time frame, you risk the option expiring worthless.
Additionally, “time decay” erodes the value of your option until it expires. It also accelerates the closer the option gets to expiration.
Unless the chart shows a promising setup developing in good time, you need to consider exiting the trade.
The Importance of Volatility
Beyond price and time is another key factor… volatility. It has a major impact on option values.
When volatility rises, option premiums increase… and vice versa.
Ideally, we buy options when volatility is low and increasing.
And when we sell options, we’re aiming for the opposite. We want to sell when volatility is high but falling.
Getting this right can have a major bearing on the success of an option trade.
If volatility doesn’t move in the desired direction, it can weigh on our trade – even if the underlying stock moves in the right direction.
So volatility’s movement can add another reason to exit an option trade.
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When to Exit
As we’ve discussed, price, time, and volatility all play key roles in options trades.
So when you’re wondering whether you should exit a trade, be sure to consider all three elements.
Perhaps you’ve gotten most of the price move you were looking for… but you haven’t quite gotten to your take-profit level.
The time left before expiry will tell you whether you’re better off taking your gain as it stands or holding out for bigger profits.
Or perhaps your option is close to expiring for a loss… but volatility is suddenly spiking. That too can offer a clue for your exit.
These are just examples, but you can see how these three factors can interact to help inform your trading decisions.
And in the end, if you keep these factors in mind, you’ll greatly improve your chances of making money trading options.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict