Managing Risk in Stages

Closing a Position

Stage Coach
Stages. Google Images

When an option trade goes awry, the intelligent trader does not double down in an attempt to get back to even. Nor does he/she hold onto the position -- hoping that something good will happen.

Instead, when the position becomes uncomfortable to own, the successful trader takes steps that reduce either (or both):

  • the sum at risk (i.e., if the worst possible outcome occurs)
  • the probability of losing more money

    The easiest -- and often the most efficient -- method is to close the entire position and accept the fact that this trade was unprofitable.

    However, there are occasions in which you, the trader, still want to own the position, but recognize that the chances of losing even more money on the trade have increased. In that situation, it pays to adjust (i.e., make changes to) the position so that you are comfortable holding onto the newly adjusted position. 

    EXAMPLE  NOTE: This is an example, and not a trade recommendation.

    If you are bullish on the overall market, one possible trade is to sell an out-of-the-money put spread on SPX (S&P 500 Index) or SPY (an ETF that attempts to mimic the performance of the S&P 500 Index). The trade plan calls for closing the position when you are satisfied with the profit -- or perhaps allowing the options to expire worthless. With a bullish outlook, you plan to profit as time passes and the market price for the spread moves from $1.00 towards zero..

       Buy 5 SPX Sep 18 '15 1860 puts
       Sell 5 SPX Sep 18 '15 1870 puts
       Credit $1.00 per spread.
       Time to expiration: 71 days

       Maximum gain: $  500
       Maximum loss: $4,500 
    NOTE: Be certain that the maximum possible loss is within your risk tolerance for any trade. Do not make the mistake of believing that the probability of earning a profit is so high that you can afford to trade more size (i.e., a larger position) that is appropriate.

    That mistake is the leading reason why both experienced and inexperienced traders go broke.

    Because SPX is priced near $2060 as this article is written, the options in the spread are far enough OTM to satisfy the needs of a trader will a bullish outlook. However, we know all to well that surprising events occur every so often, and it is possible to lose the maximum, or $4,500.

    The prudent trader does not allow that large loss to happen. When danger lurks (risk increases) and you become concerned about the outcome of the trade, that is time to take some risk-reducing action.In other words, it is time to manage risk.

    Let's assume that world events spook the stock market and that two weeks after you make this trade SPX has declined to $1950. That may seem to be a large decline, but it is only 5%. 

    Your short option is now only 80 points out of the money. Let's assume that it felt "safe enough" to take the risk involved with selling this spread when the short option was  190 points OTM. But now that the market declined, you are not as confident about earning a profit with this trade.

    You may still have a longer-term bullish bias, but it is obvious that the shorter-term outlook is questionable (at best).

    If you still like this position, I offer two suggestions. Note: If you do not still like this position, then get out. Buy the spread and take your loss. Do not hold onto a position just because it is in your account. Do not own a position unless you want to own it.

    1. Cover a portion of the position. This reduces the sum at risk. In other words, buy 1 or 2 spreads and remain short 3 or 4 spreads. This is a Stage One adjustment. If the market falls further and if you still want to own the position, remain short only 2 spreads and buy back (cover) the remainder. This is the Stage Two adjustment. If you become nervous about the position a third time, then cover your remaining position.

      This is an example of exiting the entire position with a Three-Stage adjustment. You may decide that a Two Stage, or Four Stage plan is better for your needs.
       
    1. Change the position to reduce the probability of incurring additional losses. VERY IMPORTANT NOTE: Do not make any effort to recover your loss while making this adjustment. In other words, do not sell additional spreads so that you can bring in extra cash. This is a common mistake for inexperienced traders who want to take every possible step (while ignoring just how large risk has become) in an effort to turn this money-losing, high-risk, position into a profitable trade.

      Example:
        Buy 5 SPX Sep 18 '15 1860/1870 put spreads (to close your position)

        Sell 5 (and only 5) SPX Sep 18 '15 1820/1830 put spreads (to open a new position)

        or

      Sell 5 SPX Oct 16 '15 1750/1760 put spreads (to open)
      If this is the October spread that you want to own, then this is the best spread for you to sell. Do not sell a higher-priced spread in an attempt to recover current losses and come out with an overall profit when all is said and done.

    It is acceptable to move the position out to October when it is a position that you want to own. Because risk management is essential to your long-term success, do not feel that you must collect more for the October spread than you paid to exit the September spread. Prefer to own a position that is comfortable to own.