If you know me, you know how much I talk about being a risk manager. Over the past couple of weeks, I have been trying to drill that point home to every option trader I encounter. There is nothing more important than how you manage your trades. End of story. I often say, “know what you will do no matter what happens before you enter a trade.” It sounds like a simple and relatively easy thing to do, but you would be surprised how many traders fail to do it. Many traders get so excited about the entry they hardly think about the management of the trade, aside from hoping for a big profit.
Bull Call Spread Example
Let’s say you see a stock breaking over a resistance level and you think it can continue to move higher. Based on your research, a bull call spread is your choice to try to capture a profit. Before you enter the trade, there are several things to think about. When am I going to exit and take a profit and a loss? Should I use multiple exits for profit or loss (for me, always multiple exits)? Will I use hard or mental stops? What if my stops or targets are exceeded? There are several different scenarios that can play out and you need to be ready for any (and sometimes several) of them over the course of the trade.
For the bull call spread example, a trader can consider taking a 20% to 25% profit on some contracts, then moving the stop loss up to breakeven if not better and then going for a bigger target like 40% to 50%. At the same time, he or she can set up a stop loss (hard or mental) at 25% of the cost of the trade or close out some of the position if the stock closes below the support level. If the target or stop loss is exceeded because of a gap or a big move, the trader could close out the whole position.
Final Thoughts
The bottom line is, there is a lot to think about and it needs to be done before entering the trade. That way the emotional trader does not make the decisions once the position is on. Good luck and Happy Holidays!
