Preserve Option Profits with Time Stops

06/25/2012 12:23 pm EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Price-based stops are most familiar to traders, but Dan Passarelli explains that time-based stops can also allow for effective risk management while minimizing the destructive impact of time decay.

Learning to trade options offers a number of unique advantages to the trader, but perhaps the single most attractive characteristic is the ability to control risk with surgical precision. Much of this advantage derives from the ability to control positions equivalent to stock with far less capital commitment.

However, a lesser-discussed aspect of risk control is the ability to mitigate risk by the judicious use of time stops, as well as the more familiar price stops more generally known to traders. Because time stops take advantage of the time decay of extrinsic premium to help control risk, it is important to recognize that this time decay is not linear.

As a direct result, it is not intuitively apparent the time course that the decay curve will follow.  A corollary of this is that option modeling software is essential to plan the trade and decide the appropriate date at which to place a time stop.

As a simple example, consider the case of a short position in Apple (AAPL) established by buying in-the-money July 595 puts. A trader could establish a position consisting of ten long contracts with a position Delta of -603 for approximately $24,000 as I write this.

See also: Delta: The King of All Option Greeks

At the time of this writing, the stock is trading around $587.50; these puts are therefore $12.50 in the money. Let’s assume a trader analyzes the trade with an at-expiration P&L diagram and wants to exit the trade as a stop loss if AAPL is at or above $592 at expiration. The options expiration risk is $16,000 or more. However, if the trader takes the position that the expected/feared move will occur quickly—long before expiration—he could implement a time stop as well.

Using a stop to close the position if the stock gets to $592 at a point in time around halfway to expiration would reduce the risk significantly. Because the option would still have some time value, the trader could sell the option for a loss prior to expiration, therefore retaining some time value and fetching a higher price.

In this event, closing prior to expiration helps the trader lose less when the stop executes, especially if there is a fair amount of time until expiration and time decay hasn’t wreaked too much havoc.

Options offer a variety of ways to control risk. Learn and use all risk control maneuvers available; life is a risky business.

By Dan Passarelli of MarketTaker.com

Related Articles on OPTIONS