Cost Averaging Options Trades

Tom Gentile

Posted in
Education

By: Tom Gentile
February 17th, 2023

4 mins read

When trading options like trading stock, there are times when the trade goes against you.  The question is when to either stop out and preserve capital or add to the same options trade resulting to what’s known as dollar cost averaging.  Here are some thoughts on that.

Recent followers of my education know I highlighted a bullish 5-month pattern for the Energy and Oil sector. It typically runs from mid-February to mid-July.  The date chosen for the start date of the pattern is usually February 14.

The security used to assess this bullishness is the United States Oil Fund

That day of the week this year 2023 was this past Tuesday.  Based on today price action the USO and other energy and oil ETF’s and individual securities are trading down since then.

Figure 1: 60day Candle Chart on USO
Figure 1: 60day Candle Chart on USO

Over the 60-trading day view it shows USO is more in a trading range sideways than in any kind of trend, up or down.  Despite what happens over a day or two or the anticipated move over the next 5 months is higher.

Stop Out or Add to the Trade

What you do with any investment on any security is up to you and your financial professional and when it comes to an options trade even that is up to all of you.

Because I am an options trader I will give you some insight as to my consideration when an options trade of mine starts to work against me.

If your rules-based approach calls for a stop loss of a percentage dollar or percentage amount and that option hits either of those consider stopping out.

For an options trade, know how much time you have until the option expires.  If you believe it has time to recover and do better than it is right out of the gate then you can decide to either hold on to the trade at current prices or consider dollar cost averaging.

If you bought an option say for $2.50 and it is now trading at $1.00 a consideration is to add the same number of options you originally bought at $2.25 at the now price of $1.00, (let’s just go with 1 contract to keep things simple).

Again, I consider doing this if I believe I have enough time until expiration for the security to trade higher.

You have now accomplished two trades in which you have spent a total of $3.50 or $350, (and I would still consider myself having only one trade/position in my account), but the average price cost of the option is $1.75 per contract.  It would be like you originally bought two contracts at a cost of $1.75 or a total cost of the trade of $350.

After Averaging the Option Trade, it Doesn’t Have to Work as Hard to get Profitable

The thing now is if the security traded higher and the option was trading back at $2.50, where you bought the first option (or batch of options), instead of the original 1 contract trade being at a break even it should be a situation where the two-contract trade is profitable.

If you had two contracts at an average price of $1.75 that would be a cost of the trade now would be $3.50 or $350.  

With the option now trading at $2.50 again your two contracts would be a value of $5.00 or $500 or a profit potential of $1.50 or $150.

Originally, if you did not cost average you would have to wait for the stock to rise enough to make the option price $3.50 to see that same $1.50 increase/profit.

For the option to get back to $2.50 it means the security has come back and is trading higher.

To get the value of the original 1-option to where the profit is a $1.50 or $150 per contract the security would have to work even harder, meaning it has to go even higher in price than that.

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