by Ian Harvey
Before you start trading in stock options you need to have an exit
strategy. In most cases you need to apply a fast and hard rule to
survive. There is no one perfect exit strategy.
If you have poor money management habits, then you will not survive as an options trader. The development of money management habits explains why some people succeed in life financially while others barely get by.
Here are some common sense hard and fast rules which may help you stay in the market and be profitable. Stock options can break you or make you!
• Learn how to profit on paper first before using real money.
• Don't invest money you can't afford or are not willing to lose.
• Don't invest your entire account on one trade trying to get rich quicker.
• If you have a series of losing trades re-group and look again at your strategy.
• Diversify your investments. Don't invest solely in stock options.
• Never have your entire available capital tied up in options trades.
Emotion is one of the biggest problems when trading in stock options.
Fear and Greed become two of the biggest obstacles to successful profit making.
Gamblers call fear “playing with scared money”, and that’s a good phase to keep in mind as an investor in the market place. If you are investing “scared money”, that means that you cannot afford to lose this money, therefore emotion comes to the fore, and decisions become stilted based upon the fear of losing your money. A sure way for failure!
Greed on the other hand, takes place when a stock is doing well and your option profits are soaring, and you ignore the market signs to sell. You believe that more profits are forthcoming and hang on, and before you know it the stock has reversed in a big way and you end up selling at a reduced profit or at the worst, a loss.
Exit Strategies for Stock Options
With options trading you can close a position, sometimes known as exiting the position, at any time before expiration, with one or more of the alternatives mentioned in this article. The exit strategy you choose as well as your timing can determine whether you realize a profit or a loss on a particular trade. This is where an exit strategy is so important - plan how you will exit before you open the trade.
Just a note of interest, options holders have more flexibility than option writers when deciding on an exit strategy, since they always have the choice of whether or not to exercise. Options writers must fill their obligations if they're assigned, so exiting decisions need to be made early.
Timing is important for both options holders and writers. As expiration nears, an option's time value drops quickly, which means options holders might recover less of what they paid in premium by closing out their positions.
Closing out means buying an option you sold, or selling an option you bought — essentially canceling out your open position.
If you're an options holder you might close out your position by selling the option, rather than exercising it. If the premium has gone up since you bought it, closing out could mean making a profit. If the premium has decreased, closing out would mean cutting your losses, and offsetting at least part of what you paid.
Since you can close out your position, or buy back an option you sold, as an options writer you're almost never forced to fulfill an obligation to buy or sell the underlying instrument — assuming you close out before the option is exercised. Depending on the option's premium when you want to buy it back, you might pay less than you received, making a net profit. But there's a chance you'll have to pay more than you received, taking a net loss. If that loss is less than what you would have faced if the option had been exercised, closing out might be the best exit strategy.
Rolling Options is another exit strategy used by many investors.
Definition of Rolling
The Chicago Board Options Exchange (CBOE) defines rolling as “a follow-up action in which the strategist closes options currently in the position and opens other options with different terms, on the same underlying stock.”
In other words, an options trading rolling strategy is a strategy where you move your strike point to a new strike point during the month or another month.
Rolling basically means moving and where an investor is options trading, this movement happens when you move positions from one strike point to another. That can either happen when you move points vertically (within the same month) or horizontally (to another month) or both.
Or more simply put, rolling means first closing out an existing position, either by buying back the option you sold, or selling the option you bought. Next, you open a new position identical to the old option but with a new strike price, new expiration date, or both.
Expiration of Stock Options
For the covered call writer rolling, or “the roll”, is a strategy used by investors who wish to keep the underlying asset and generate additional income from writing new options as the older options have either expired or have been closed out. This rolling action requires the investor to write a call with a different strike price or different expiration date, or both. Basically covered call writers can roll their position forward, roll their position down or roll their position up depending on the current value of the underlying asset.
The time premium of an option decreases its value as it gets closer to the expiration date. An example of this is in the chart below. Note that the option starts to lose value more quickly at about the 60 day time period and then accelerates further with 30 days to go. Rolling options use this to their advantage.
There are certain “expiration days” that are more significant than others, such as when “witching hour” occurs on Triple-Witching days and ”Quadruple Witching” days, where volume and volatility are extremely obvious and influential.
If you hold an option and you roll before expiration, your old option might have some time value left, which means you might be able to earn back some of what you paid.
When Not To Roll
Part of options trading rolling exit strategy also involves knowing when to avoid rolling. Occasionally an investor may decide not to roll the strike position. The purpose of that is to allow the capital to appreciate more. However, this does not happen very often.
As a stock option's expiration approaches, there can be either one of two outcomes. Either the short option could be out-of-the-money or in-the-money. If the option is out-of the-money, it is worthless. The investor simply sells the next month's call, after letting the option expire. If, on the other hand, the option ends up in-the-money, in order to keep the stock all the investor needs to do is sell the next month's call after buying the short option back. Even though that sort of trade consists of two trades, buying and selling, it is considered one trade. It is also known as a spread. That way, you can buy back the short option and keep your stock. Examples below represent a call or put option spread.
Rolling can be quite complicated. However, you may find it well worth it, in the long run. The trick is to be careful to make the most informed decisions possible. Remember to never risk more than you can afford to lose either. Even with the best systems and methods there is still a great deal of risk.
'Rolling' With the Profits
There are several types of “rolls,” with each addressing a slightly different concern.
• Rolling Forward or a Horizontal Roll
This is where we move our option from month to month in the same strike. This simply means that “rolling forward” your covered call option requires you to buy back the current covered call and sell another covered call with a new expiration date that is further out with the same strike price.
Making a decision as to when to roll forward starts with whether you have an in-the-money or an out-of-the-money call option.
The best time to roll forward an in-the-money option is when the time value premium has completely disappeared.
Out-of-the-money options lose value and reach zero as the expiration date arrives. By calculating the return per day from the current call option and comparing it to the return per day from a longer term call determines when to roll forward. When the longer term call has a higher return per day, you should roll forward.
When deciding to roll forward it is always best to compare several alternatives including three or more expiration months. It is also important to keep an eye on the underlying stock’s fundamental and technical situation to help decide if this stock is the right one to continue your roll forward strategy and where the likely support and resistance levels are.
• Rolling Up or a Vertical Roll
This is where we move our option from one strike to another in the same month. In other words we have a situation where the investor is faced with two alternatives when the price of the underlying shares rises and is above the strike price. You are now in a profitable position no matter what strategy you employ. The first alternative is to sell your options and realize the returns you expected. The other alternative is to close out the original covered call and write another at a higher strike price. This is called rolling up.
Rolling up is a good strategy if you believe that the underlying stock is going to continue to perform the way you want it to. However, if you feel that the underlying security doesn’t fit to this strategy, that the stock appreciation is limited, then it is time to let the stock be called away and look for another option.
With any exit strategy there are always dangers to be aware of. In this case, by rolling up to a higher strike price you are raising your breakeven point. This does not pose a problem as long as the stock increases in price. However, if it declines you are left in a position of loss sooner than expected. This is one of several problems involved in rolling. One other to be aware of, is, when the stock price increases too quickly past your strike price and you repeat the rolling up process, maybe it is time to consider another exit strategy.
• Rolling Down or a Vertical Roll
Rolling down is when an investor with a covered call decides to close out the current call and write another one with a lower strike price. This takes place when the price of the underlying stock has dropped dramatically.
When rolling down you buy back the existing call, hopefully at a profit since the underlying stock price declined and then write another covered call with a lower strike price. However, this is not usually a good strategy, but on the other hand, if the price of your stock has fallen greatly then initiating a strategy of rolling down your covered calls would be beneficial.
Deciding when to roll down is often made by investors who use technical support and resistance analysis. Knowing the technical levels of a stock helps to determine if it is worth the risk to roll down versus the expected result of remaining in the current covered call.
• A Diagonal Roll
This exit strategy combines the characteristics and virtues of both the vertical and horizontal rolls.
In the stock-replacement strategy, normally, the vertical roll is the one that is most frequently used and most important.
As previously stated, the vertical roll allows you to lock in profits and lower risk, while maintaining the same position size. By keeping in mind the aspects of profit and risk, there is established a much easier and better opportunity to follow the full run of the stock without risking the profits already built up in the option.
With the roll technique, less fear of loss is noticeable and the situation becomes better controlled, which allows the investor to play the option to the maximum profit.
The options holder can choose whether or not — and when — to exercise, while the options writer has no control over whether or not a contract is exercised.
Options holders usually base a decision to exercise on whether their options are in the money, which is where the profit is obtained, whereas at the money, options would provide no profit, and wouldn't be worth the transaction fees. And exercising an out of the money option would mean paying more than the market price to buy shares, or receiving less than the market price to sell shares, which would not be financially profitable.
Once you've decided on an appropriate options exit strategy, it's important to stay focused. That might seem obvious, but the fast pace of the options market and the complicated nature of certain transactions make it difficult for some inexperienced investors to stick to their plan.
If it seems that the market or underlying security isn't moving in the direction you predicted, it's possible that you'll minimize your losses by exiting early. But it's also possible that you'll miss out on a future beneficial change in direction. That's why many experts recommend that you designate an exit strategy or cut-off point ahead of time, and hold firm.
No one has ever gone broke taking a profit. Remember there is no such thing as a small profit. As long as you make more money than you lose, your account will continue to grow beyond measure.
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