Posted in
Education
By: Tom Gentile
on January 9th, 2023
Managing a Loss on an Option Trade
The current 3-part series on basic option trading education is about managing your option trade. Part one dealt with when to consider taking a profit on an options trade. Today, part Two will educate you all on when to consider taking a loss on an option trade that is not working.
The next article, Part Three will be the types of orders one can consider using when closing an option trade for profit or loss.
% Stop Loss
One consideration for managing an option trade going against you is to cut the loss at a certain percentage point. A commonly considered stop percentage is a 50% stop.
If you bought to open an option at $4.00 or $400 dollars a 50% stop would be $2.00 or $200.
The train of thought here being that even though you cut your loss at 50% you are able to protect/preserve 50% of your capital to use to trade another day.
Dollar Stop Loss
Instead of cutting losses with a certain percentage stop amount to the cost of the trade one can consider a certain dollar figure amount of the cost of the trade as the amount one wants to risk.
It can be based on a percentage or a set dollar figure amount. An example would be $500.
If you bought options that cost a total of $1,000, $2,000, $5,000 or any other amount, if the options value goes down to where closing it out would be a $500 loss that would be where one closes the trade.
The train of thought here being that $500 is the most one wants to risk and no more.
Technical Stop Loss
Using either a percentage loss or dollar amount loss can be considered arbitrary. The only reason you would stop out is because you pre-picked that percentage or dollar amount ahead of times based on basically it just feeling like the right thing to do.
There are times one can get stopped out at their predetermined percentage or dollar amount and the security ends up working out and moving in the direction anticipated after all, ONLY to see you not being in the trade and participating in pending profits because you stopped out too early.
Has that happened to you? Or should I ask again, How many times has that happened to you?
Not a great feeling. One thing to consider is using a technical stop instead of an arbitrary number.
One can use the technical picture or chart on the underlying security and determine a price level on the chart that shows the security is not trading in the direction needed for the option trade.
The above chart is a 150-day candlestick chart on Hasbro, Inc. (NYSE: HAS).
The horizontal green line represents what one could consider a support line, indicating that is a price where HAS trades and gets supported from going any lower. One can see it has tested that price area a few times and bounced a bit higher from.
If one were to take a bullish option trade, anticipating the stock trading higher the price in which one says if it breaks a technical support area on a closing basis it is time to close the trade and move on.
This way, the stock can trade down a bit and you don’t have to worry about it being down a percentage amount or a dollar amount and you stopping out only to see it turn around and start working.
Keep in mind, a technical stop doesn’t prevent it from turning around and working, but by the nature of it breaking a technical support (in this case) price it is likely less inclined to turnaround right away since other technical traders see that it broke support and may keep them from spending more money on a stock breaking down and it is best you stopped out.
Figure 2 shows how the breakdown of support on HAS lasted awhile and trade much lower meaning it was wise to have used that technical support price area as your technical stopping out point.
To end Part Two Options Trade Management Discussion
Now that I have written all this, realize the piece I wrote on December 19th, titled An Options Trading Management Consideration, discusses the concept of Cost as Risk. If one chooses to adopt that process and places trades with the position size, number of contracts, as taught the loss considerations taught here may not be necessary. That is for you and your broker to decide.
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