Knowing when to get into a trade can be a whole lot easier than knowing when to get out.
Perhaps it is has to do with psychology. You enter into a trade based on a technical signal from a chart. Or, you have thoroughly researched a stock’s fundamentals, and believe it is a good buy.
Whichever method you use — and it could be a combination of the two — you buy into the stock in anticipation of it doing well.
In doing so, it feels like a positive thing. You’ve been through your checklist, and are now ready to go.
However, if that positive anticipation turns into regret as the share price goes the wrong way, getting out can really raise your temperature.
Part of that angst can be finding it hard to admit you are wrong. But ego aside, there is another reason…timing. That is, the time you were planning to hold the shares.
If you bought shares in Commonwealth Bank of Australia [ASX:CBA] at its float, just about any stop-loss strategy would have likely thrown you out of the stock dozens of times over the last 25–30 years. But would you have got back in?
As the share price rallied from single digits to almost three (digits), every time you saw the share price, you couldn’t help but give yourself another kick.
The other thing is history. You might have strictly followed a stop-loss strategy in the past, only to see the share price rally strongly after getting out of the stock.
There’s no way of putting any positive spin on it. Yep, you stuck to the plan and congratulate yourself for that. But it really is of little comfort, when you miss out on a nice, tidy profit.
More than just price
While price forms the primary trigger for most stop-loss strategies, it is not the only one. Other strategies use time.
Meaning that if the share price hasn’t done what the trader predicted by a designated time, they exit the trade. With that money sitting there in the trading account, they can readily put it towards their next trade.
The share price might have gone nowhere or even up a bit. However, the catalyst the trader was hoping to propel the stock higher failed to materialise.
For option traders, though, using time is nothing new. Because all options have a finite life, time is an important component of any strategy. The moment an option lapses at expiry (without exercise), it ceases to have any value.
Because of that, an option trader is always thinking about time.
As an option buyer, time works against you. The move you are anticipating needs to come before the option expires. Otherwise, you will lose the premium you pay.
That’s why option traders might exit the trade based on time. Like, for example, 45 days out from expiry. They know that the time decay of the option will start accelerating then, so they get out before that happens.
For the option writer, though, time is their ally. Each day the option loses a little bit of value as it gets closer to expiry. What the option writer wants is to go into expiry without exercise. That way, the premium they receive for writing their option stays in their kitty.
The other dimension
However, there is also another way that options are different. And it has to do with volatility.
Like price and time, volatility also plays a huge part in the value of options. And because of that, traders can use a change in volatility as a way to exit a trade.
An increase in volatility increases the value of an option. And the opposite applies — a decrease in volatility lowers the value of an option.
Apart from a rallying share price, the option buyer also wants volatility to increase after they buy an option. In doing so, it can increase the profitability on a trade. They can sell the option for a profit, and not worry about exercising it.
What they don’t want is to buy an option when volatility is high, only to watch volatility decrease. If that happens, they can lose money on the trade, even if the share price goes the way they want.
For an option writer, the opposite applies. They want to write (sell) an option when volatility is high, and buy it back when it is low (or take it into expiry if a buyer is unlikely to exercise it).
What they don’t want is for volatility to increase, after they write the option. Just like an option buyer, they can lose money on the trade even if the share price does as they hope.
That is why volatility can form another part of a stop-loss strategy. For the buyer, they might exit if volatility drops below their target. And for the option writer, they might exit the trade if volatility rises above their target level.
Editor, Options Trader
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