Author: Chris Hood
Be sure to check out new episodes of my video podcast each week, where my ace pupil Brian Jones and I talk the ins and outs of options trading- and give you insights and strategy that you can immediately put to work for you in the markets.
Raise your hand if last Wednesday’s big sell-off after the Fed meeting battered your bullish options positions.
Mine is up.
And I’ll bet a lot of newer traders out there found themselves in full-blown panic mode, closing trades near the bottom of that big red candle for substantial losses.
The technology sector got hit particularly hard.
High-beta stocks whose companies carry considerable debt don’t respond well to continued news of interest rate hikes. We saw quite a bit of big money rotating out of the NASDAQ and into the energy and financial sectors.
Whether or not there’ll be a nice recovery bounce or rally in the next few days remains to be seen. However, anything is possible, so I’m holding onto a few of my trades just in case.
I’ve spoken to many panicked clients this week who wanted to know whether they should stay in their trades or get out.
Will this selling continue?
Can my trades recover?
Should I cut my losses and move on?
It’s an important enough topic that I thought I’d try to give you two guidelines on how to navigate sudden, unexpected drops.
First, follow your exit plan rather than your emotions.
If you’re trading correctly, just look at your notes and/or follow your alerts. They’ll tell you what to do.
Did the down move trigger the stop loss you set when you went into the trade? If so, then exit, and if not, stay in.
How far you’re willing to let a position dip before you sell should be written into your trading plan. Remember, each trade must include a plan for taking profits and cutting losses before placing it.
You can base your exits on breaches of key support levels, moving averages, the price of the option, or some combination of these.
For instance, I often trade using the following exit strategy.
If the underlying stock closes below the 8 EMA and the option is down 25%, I exit.
No emotions or hesitation are necessary.
Sometimes news or other events (like a Feb meeting) can knock your position down a bit without significantly changing the technical signals. So it can be a good idea to wait a few days to see if your trade can recover.
Often these dips aren’t institutional selling but panicked retail investors.
The market typically recovers quickly after pullbacks of this sort.
Assuming you do get a bounce, you’ll need to realistically assess whether or not your trade is still valid.
How much time is there until expiration?
Short-term volatility won’t have the same degree of impact on a call option with 150 days until expiration than one set to expire in 30 days.
Time decay (theta) will erode the option value faster than it can move up with increasing stock price (delta). Best just to cut those short-dated options loose.
Is the trade structure broken?
Unless you’re trading intra-day or only holding day or two, bullish trades should be entered only on uptrends.
When a position takes a hit from market price action, it’s essential to ask whether or not the movement changed the trend.
An intact trend on trades with ample time should mean you’re ok to stay in.
Thus a good rule for your plan might be:
If the trade triggers my stop due to news, I have more than 60 days until expiration, and the stock closes above the 21 EMA, then hold.
There’s no reason to wonder and panic if you have rules in place.
So plan ahead and stay calm.
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