In the first two parts of this series on options, I introduced the trading tool and how to get started using it. Here, I'll dig into the most important part of trading options: managing the trade.
While it is important to select the right option and expiration date of an option, it is critical to manage the trade to minimize loss and maximize gain. As an options player, we wear many hats, but the most important one is risk manager. I am always looking for a way reduce my risk, and that idea starts well before I even make a trade. With the element of time detrimental to the option buyer, we need to figure out a way to overcome option decay, in the most efficient way possible and still participate in a trade.
One of my favorite strategies for managing options trading risk is the roll strategy. After entering a trade that becomes profitable, I am constantly looking for ways to take money off the table and still have the opportunity to participate in the direction of the trade. There are numerous ways of doing this, as a reminder there could be many right answers, not just one. Let's say for instance I recently bought Alphabet ( GOOGL) July $110 calls at $4.60 per contract. The stock has made a huge run higher of late, and now the stocks is well over $112 per share, and my options have exploded up to $7.45 per contract.
This option is now up 62%, or 2.85 cents per contract. In dollars, that is $285 of profit for my risk of $460. But with time against me, that profit is at risk. But, I have now looked at the chart and it appears more upside can be obtained with Alphabet. So, my roll up strategy is this: Sell this contract immediately at $7.45, taking in $745. Buy a higher strike, the $115 call for July at $4.70 per contract, or $460. So, now I still own a Google call, a higher strike but have only my original capital at risk. I have taken my profit and put it into the bank to use on another trade if I choose, this is called rolling your option up. But the great thing is booking a profit and taking risk off the table, but still having a position working.
This is a good example of the type of flexibility and leverage that options will give you. The stock of Alphabet likely rose 4%-6%, but the option return was about 62%. That is about a 12-to-one leverage factor of the option over the stock. But you can only take advantage of the leverage if you're willing to sell, I like to call it "moving your feet." How bad would it feel if you had that nice profit and suddenly it slipped away from you? It can happen very easily. Remember, it is you that controls your option trades, it is you that books a winner or a loser.
We can also size our trades in a way to take risk off the table, too. Let's say our normal trade size is five contracts. We can size it down to three, still have exposure to the name and have less risk on the trade.
As another example, let's say you bought some Microsoft ( MSFT) calls recently. The stock has been moving sharply higher and you're ready to participate in some upside with other traders. You buy a call that is out of the money. With Microsoft trading at $313 per share you decide to buy some 315 July strike calls at $12.45 per contract. Since this is rather expensive and slightly above your maximum trade size, you buy only one contract, but that will cost you $1,245. Suddenly some volatility enters the market and Microsoft starts to move, but mostly to the downside. The stock comes down 5% to the $300 level, and now your option is worth $7 per contract, or $700. What to do now?
This is the point where most option players have the most difficulty. Some may want to buy more and average down. Before I start throwing good money after bad, I ask myself: Would I buy that option right now if I did not own it'? If the answer is no, then I would not add more contracts under any circumstances. Nobody wants to take a loss on a trade, but sometimes it is inevitable. We must be honest with ourselves and look objectively at the trade, how much time is left, the probability of getting in the money and the potential for losing even more due to time decay.
At some point, you must raise the white flag of surrender and just call it. There is no shame in taking a loss. I say this and think this all the time: "It is OK to be wrong, it is not OK to stay wrong."
That said, if you have a rule in place that says at a 50% loss for example, it is time to cut the trade, then you do it, no questions asked. Saving your capital is just as important as growing your capital. That next winning trade could be right around the corner, but if you're stuck in a losing trade that has little chance of coming up (save for a miracle), then you are spinning your wheels just waiting for that option to expire.
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