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Subtitle: Divert early and avoid the rush.
When you fly sometimes you can’t get to where you want to go. When your destination becomes inaccessible, you need an alternate listed on your flight plan. I also told the pilots under my command that if ceiling or visibility at their destination fell below limits, they needed to divert while they still had plenty of fuel to easily reach the alternate. Plan A was to land at the assigned destination. Plan B was to land at an alternate. Any other plan would lead to catastrophe. When you open a new trade, you also need to have a destination and an alternate.
The destination for a trade is the level of profit you expect to receive. You may calculate it as a value associated with the price of the underlying, a profit level for the trade, or a time when you no longer want to be invested in the trade. You have the same choices when considering when to exit an unprofitable trade.
Setting the profit target. On vertical spreads I set my profit to 80% of my max profit. I may adjust that lower if the value of the option pops quickly. My thinking is that if I get a return of, say, 50% within a day on an option that won’t expire for another two weeks, why not turn that unrealized gain into a realized one. Take that money off the table and look for another great trade. Keep in mind that profit alone doesn’t fully evaluate a trade. Profit divided by time is the metric to use. Making 10% in a day is far better than making 10% in a year. Also recognize that as unrealized profit accumulates in a trade, the risk of loss increases. For example, imagine a vertical spread with a max profit of $50 and a max loss of $150. It’s gone well and if you close it after a few days, you will see a gain of $40. The risk on the trade is now $190 on the spread. Review trades every day to see of they still make sense in terms of risk and potential profit.
Setting an exit point to stem the loss. Despite their best diligence, all traders suffer trades that lose. Because losing is painful, it’s tough to exit with a loss as fear and greed commandeer your thought processes. Determine when to exit a trade should it go bad at the time you open it. I usually peg this exit point at the break-even point for a vertical spread. As the trade matures, I’ll adjust closer to the level of the short strike. I’ll never let a spread expire in the area between the short and long strikes. This is an important dictum, and a future post will analyze it in detail. For now, though, let’s look at some mechanics of trade management.
First things first. Submit an OCO orders for both exits when the trade opens. OCO is short for One Cancels Other, meaning that two conditional orders are submitted, one of which will control the exit at the profit, the other of which will execute the close to minimize loss. Different brokers and different platforms have various ways of issuing orders like this, but I’ll provide an example of how I set up such orders. I currently have a bull put vertical with Morgan Stanley (MS). The short strike is at 85, the long strike is at 83. I have 6 contracts. Max loss is $477, max gain is 123. DTE is September 16, 2022, this coming Friday. Here’s the profile for the trade.

I opened the MS trade last Thursday, September 8, and it has gone well. When I opened it, I submitted an OCO order consisting of two trades, one for profit, one to contain possible loss. The profit trade is a limit order at $0.08 which would return a net profit on the six contracts of $99 before considering fees. I set the loss containment level to close should the underlying (MS) descend to or below the breakeven level of $84.50, 80% of max profit. If I close the trade now, I would realize a gain of $60. I’m tempted to close it. Do the math: a $60 gain for four days of risking $477 yields a percentage profit of over 12%, which translates into an annual percentage of over 1100%. Closing early at this level merits consideration, but in the meantime our OCO orders have us covered as we mull over this trade. If the internet goes out, or I go off the grid for a few days, or just don’t feel like trading this coming week, I can do so with but one worry: what happens if MS descends to between the strike prices and expires there. That could be catastrophic, because I’d be committed to buy MS at the short strike price of $85, but I’d no longer have the option of buying MS at the long strike price of $83. In other words, risk would be significantly higher. The safest thing to do if I can’t monitor the trade would be to revise the loss containment upward to a point above the short strike point.
Unlike the MS trade, my IBM trade is not doing well. I opened it on the 6th, last Tuesday. It’s a bear call vertical with a short strike of 130 and a long strike of 131 expiring on Friday of this week. The trade consists of 6 contracts. I used the same technique described above to use an OCO order set to set up my exit points. Here’s its profile.

Since the opening of this trade, IBM has tracked the broader market as it rallied over the last three days. It’s movement towards the losing side of this trade is worrisome. The max loss on this trade is $462. I could wait and see if things turn around. After all, time is on my side. If I do nothing and MS doesn’t go higher, the trade will return a good profit. Generally, I’ll hang onto a trade as long as theta is positive and I’m not concerned about assignment on the short strike. But what if the rally continues? Then I have two choices. The obvious one is to close the trade and swallow the loss well before it hits the max. Currently, that would amount to a loss of $84 before fees. There is a less obvious course I could take. What happens if we open a bull put vertical to counter the loss? Let’s take a look at what happens to our profile.

Combining an OTM bull put vertical with an OTM bear call vertical results in a trading profile that’s called an Iron Condor (IC). Many traders, myself included, treat an iron condor as two separate vertical spreads. Our max risk on the trade is now $360 and the max gain is $240. The high side breakeven point has moved higher to $130.40, giving a little more breathing space. There is a risk that MS could see a spike in volatility, reaching the upper loss area of the profile and then descending to the lower loss area. Technical analysis might provide a basis for judging which approach will do more to minimize what what appears to be a likely loss.
Loss mitigation. Over the weekend IBM continue its upward trajectory and exceeded the level I’d set to limit loss on the trade. What happened with IBM demonstrates what some traders refer to as weekend risk or after hours risk. I knew that my order to close the IBM trade at market would result in a loss, and I was resigned to it. The best I could do was to mitigate by trying to offset the loss with a gain that could be achieved by opening a new bullish trade. Within a couple of minutes after market open, I succeeded in opening a bull put spread with strikes at 127 and 126 for a per contract credit of $0.24. At the same time my stop loss exit closed the original contract at market for $0.61. My net per contract loss on the original trade was $0.38, which amounted to a total loss on the 600 shares involved of $228. About an hour and a half later I saw that I could close my second trade for $0.09, a profit of $0.15. This action left me with a combined net loss on IBM of $0.23 per share for both trades. Multiplying that loss by the 600 shares involved left a loss of $138. Quick action this morning recovered a significant amount of the loss on the original trade. It’s never good to lose money on a trade, but losing less is always better than losing more. Notice in this example, The $138 loss is considerably less than the maximum risk of $462 I had accepted on the original trade. You never want a trade to get close to max loss.
Key take-away: Establish exits both for profit and to mitigate loss when you open a trade. Update exits as conditions change, not on the basis of fear or greed.
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