Fixed Percentages
When to sell? When trading stocks the answer is often not that challenging. As a longer term investor all you need do is glance at stock ranking services such as Zack’s, Investools or Investor’s Business Daily to note how few fundamentally attractive stocks exist relative to mediocre or unattractive stocks. Once a stock is overvalued – and various measures (e.g. PEG > 2.0) indicate when that is the case -then it is time to sell.
But determining when to exit an options trade can be an altogether different game. When should you sell a put option, when should you sell a call options or exit a calendar spread. How does your exit change when trading a bull call spread versus a ratio call backspread? What happens when an event is coming up?
When I first sought the answer I used hear generic rules thrown about such as "Always exit when you have made a 20% profit" or "With options you shoot for the big winners, 100% gain minimum, because so many losers will exist". None of these exits resonated with me because of a philosophy of mine which is that "Everything Always Changes". All we need do is look at our kids grow up or a picture from ten years ago to note that nothing stays the same for long and it’s true in the stock market too. This means that making a bold, unyielding statement like striving for a fixed percentage reward every time is a loser’s game.
When To Sell?
Lots of technical triggers indicate when to exit a bullish position. Some like to use the RSI dropping below 70 as a trigger, some like to use stochastics coming out of overbought regions, some like to use crossovers of two moving averages, some use the MACD, some use crossovers of a single moving average, some use Fibonacci retracements, some use Japanese Candlesticks. Technical analysis may not be the crystall ball we wish for but it does provide a systematic approach to trading that can be repeated time and again. Of course, it won’t always work but for many it is a preferrable choice to the alternative which involves relying on intuition or worse still, greed and fear.
In early November when we saw market leader Google take a big tumble we encouraged heavy hedging to protect profits and principal. More recently when we saw the market leaders regain footing and the indexes follow we changed to a more bullish stance. Now that the market has run up to an extent should our exit points stay the same as they were just a week or so ago?
Event-Driven Decisions
In my opinion, the answer is a resounding No! While it may be appropriate to shoot for aggressive returns when the market is surging, the longer the trend continues, the more conservative the target percentage should be. Over the past few weeks many stocks have made big runs and I would rather see a bounce off some uptrending support lines before initiating exceedingly bullish positions because we have a BIG event coming up this week. Although it is widely expected that we will see a Fed cut, you need only read Phil’s latest post to get a snapshot of why numerous reasons exist to stay cautious.
I Digress!
I chatted with one associate recently who has made hundreds of millions of dollars in real estate and stated that when he buys property he generally assumes that inflation will run at approximately 10% per year. Of course, you won’t see this reported in the official figures but it was indeed amusing (in the worst sort of way) to see this figure agreeing closely with the 10% CPI figure Phil referred to in his recent article. Is the lesson to borrow heavily and invest in securities/commodities that appreciate in value in line with inflation because the dollar debt will essentially be lower in a year’s time? If only choice investments were the reason so many are in debt!
Exit Points
As we approach another uncertain event it’s time to re-evaluate virtual portfolio positions and the level of hedging. Some level of heding is always prudent and at uncertain times it is wise to increase the level of hedging. If this means missing out on the first leg of a gigantic run so be it. How awful would you feel if you were to go into an uncertain event with no hedging and suffer a huge account hit because of a massive decline?
This strikes at the core of successful option trading: Focus as much on the risk of your positions as the reward. Any novice can think about how much money will be made when all goes well but few account for a looming disaster. The separation between the successful and the average trader can simply be the difference between factoring in risk and taking action versus not doing so.
The natural tendency of the market has been to rise over long periods of time so maintaining a bullish bias is prudent but if you are happy with how your virtual portfolio has done this year and would be really crushed in the event Bernanke and friends failed to placate the market, then don’t forget the option to hedge a little. It can’t hurt much if the market goes higher but it can hurt a lot if no hedging is in place and the market moves the other way!
Even if you did purchase some put options for the event and then the market went higher, all you would need do to recover much of the original capital is add some short puts against those long puts (probably at a higher strike price since the market would have risen). This would create a bullish spread. Approaching the market with this view means prudently hedging when necessary but adapting to the market when appropriate. By so doing you will be adhering to our philosophy and Phil’s motto that there is ALWAYS AN OPTION!
Have a Wonderful Week!
OptionSage
