Are You Planning Every Exit? Six Steps in Practice

06/01/2010 12:01 am EST


This is a follow-up article to our latest piece on the Six Steps of Option Trading.

This article is titled “Are You Planning Every Exit?” for the simple reason that there should always be more than one possible exit strategy for every single option trade that we make. Since the stock market on any given day could move in three possible directions (up, down, or sideways), we must have multiple exit strategies for our option trades. In the end, there are going to be only two points recorded in our trading account as the outcome of the filled orders: The entry and exit. The other two exit strategies, which were never executed, will remain as canceled orders only. However, not every option trader has the discipline and training to think multi-dimensionally. Single-dimensional thinking anchored in optimism is what I encounter the most, while professional option traders are somewhat pessimistic.

Most of the time, new traders are too eager to jump into the trade without proper planning for the exit. (Notice that I used the singular noun, the exit, for they often do not even have a single exit, never mind multiple ones.) It is within our human nature to act impulsively at times. The more experienced at trading we get, the more we are able to control our impulsive nature.

Having addressed this, I wish to scrutinize a recent trade taken by a student. Briefly, a novice trader placed a Bull Put on a product that he had never traded before. It turned out that the product was an inverse ETF, which moves three times as fast as the underlying which it follows. Hence, if the real product goes up, which in the last six weeks it did, this inverse ETF goes down three times as much. I had no idea if he was still in it or not. Just before the expiry, I received his e-mail pleading for assistance. He was still sitting in a trade that had gone over ten points against him. I was speechless.

In hindsight, I can explain what happened, and moreover, I would like to use this painfully expensive lesson as something to guide the readers away from placing similar trades. In order to highlight what the trader did wrong, I will share my trading routine. The steps which I normally follow come directly from the CANSLIM method of William O'Neil. After all, those are my trading roots from which I have evolved into option methodology. Figure one addresses six stages and the action that each involves. The last column presents my opinion of what the trader has omitted from the planning and trading stages that I use.

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The first four stages are about planning, and only the last two are about actual trading. Hence, I start by looking at the fundamentals first so I can be aware of important upcoming events such as earnings releases, stock split dates, or dividend payouts. In the case of inverse ETFs, many of these fundamentals simply do not apply, so in this step, the trader did not make any mistake even if he unconsciously omitted it.

Next, I move to the technical analysis stage, during which I observe the intermediate trend and locate support and resistance lines. As described in our last article, the trader did look at the chart, but he misread support. He entered his bullish position after it had broken support. It was at the entry point that the decision error was made.

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The third stage in my planning approach is the option strategy selection. At this point, I look at the implied volatility (IV) on, and if the IV is high, then I sell expensive and overpriced options. The trader observed this step, for indeed, he placed a vertical credit spread. Too bad it was not a bear call instead of a bull put.

The fourth step that I do is proper position sizing. I know the trader personally, and without disclosing anything inappropriate to the public, he oversized it. I wish that he did not, but he did. The market is going to hand us the same lesson whether we have gone wrong with a single contract or with eight contracts. Nevertheless, because of our human nature, we tend to remember longer the negative and big painful lessons more than the smaller ones. Once again, I must emphasize the importance of proper position sizing prior to the entry. It is at this point that I also need to introduce the concept of a "foot soldier." I have picked up this nugget of wisdom from the floor traders who tend to place a single contract just to find where "the true market" is. Once again, they are fishing in between the best bid and the best offer. Once they find "the true market," it is then and only then that the rest of the troops (contracts) are ushered in. The trader did not do this step either.

At this point, the planning is done and the trading is on. Once the position is open, it must be actively monitored. It is an option position, so we must be aware of any change in implied volatility as well as in the price. We need to ask ourselves two crucial questions: Is the IV hurting or helping our position? Also, is the time and direction of the price action in our favor or not? If we conclude that either the price action or the IV is no longer on our side, then we must proceed with our predetermined exit strategies. There is no time for hesitation at this point. When the red flag goes up, we must act and act fast. These things tend to go wrong in trading many times, so we must have the will to prepare in advance for them. Plan first, execute second. Thinking is done during the planning stage, so in execution of the exit strategy, there is no thinking involved, just acting. The trader had not done the most essential part of trading.

The sixth stage, after exiting, includes learning from the trade. How much the trader is going to learn from the trade remains to be seen, yet he obviously did not have an investment plan made for his trade. No planning steps were done, no multiple exit strategies created beforehand, and no action was taken for days. He should not attempt to place another trade without a clear trading plan that includes multiple exits.

On the positive note, a big, life-changing lesson could be learned from this losing trade by recording the results in a trading journal. I suggest using the chart with text notes, marking the trade entry and the trade expectation versus what really happened. Then, print the chart up and stick it next to the monitor so that the same mistake will not be made again. The printed chart will help your retention.

In conclusion, an option trader must determine multiple exit strategies prior to the trade entry. This simple concept must not be overlooked. Instead of focusing on profits, calculate the losses first.

Good trading!

By Josip Causic of Online Trading Academy

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