Exit Strategies

The Smart Profits Report: Issue #144
Monday, September 20, 2004

Exit Strategies: Prenuptial Agreements for Options
By Mt. Vernon Research Team

The ultra-rich and famous treat getting married like a business problem. They work out prenuptial agreements to assure clean exit strategies even if the lovebirds turn into combatants later on.

These deals always sound more like an arrangement to lease a spouse than a true communion. I’d probably respond with a couple of choice words if I were ever offered one - those words being, “Stuff it, wimp.”

But when it comes to options, my attitude is wholly different. You should borrow trouble before counting on bliss. You should imagine the worst and prepare ahead. In short, you should be leasing, not committing, if you know what’s good for you. You need a prenuptial for your options trades. It’s called an exit strategy.

Using stop losses - either mental ones, or formal ones with your broker - are part of it, as Karim Rahemtulla has discussed in this space before. That’s one technique, but it’s not an exit plan all by itself.

You need an exit strategy for all options trades, and for short-term trading it’s life and death.

Know When to Say Goodbye Before You Say Hello

Actually, there are two parts to a whole exit strategy: taking profits when you are successful and getting out when you’re not, or when the trade turns around.

With options, this “exit discipline” can be even trickier than with stocks: You only own a right that becomes more or less profitable as time passes and is always speeding toward worthlessness - which it will achieve the day after expiration, if not sooner.

So how do you decide where to exit and when?

You decide before you ever buy your option. Don’t buy unless you already know when you’ll sell.

Profiting With Mathematical Certainty

There are two approaches to setting an exit point for options: mathematics and events. Both have their pros and cons. If you are just starting out, the mathematical choice will probably serve you best. But let’s look at the two alternatives…

Mathematically, you simply choose how far you’ll let an option drop - 10%… 25%… 50%… etc. - and sell automatically if you reach that place. The advantage is that it is easy to use this system. Extremely clear and very disciplined.

The other great advantage to a mathematical stop loss is that it definitely curbs your natural inclination to hang on too long. You don’t question. Say you decide to get out if the option falls 30%, for instance… If it does, you leave.

But with a good plan, following preset stops faithfully and without fail will work to your favor far more often than letting emotions rule and overlooking them. A good plan will work out.

Technically, You Have Lots of Choices

I’ve tried a number of mathematical stop positions with options, and for short-term options, here’s what I’ve found. A tight stop will jerk you out too often. If you set your stop at 10%, which could work with stock trading, you will be stopped out of more trades than you’ll ever manage to follow to profits.

Even a 25% stop loss is a bit tight for short-term options, as this is in the range that an option on an active stock can move erratically in a day, especially after factoring in the spread. The spread between the ask (where you get in) and the bid (where you’ll get out) is normally at least 5%, usually 10%, and quite often more than that.

Instead of a tight stop, 33-35% is more reasonable. Fifty percent is best for me, but I also have a system that gives more winners than losers and the average wins tend to be larger than the average losses.

But there’s another choice if you seek meaning in your life and your trading: an event-based stop.

Options Trading Based On Current Events

These are based on technical analysis. By looking at chart patterns, trends and various indicators, the technical trader will choose a stop point based on a change in direction for the underlying stock. An event, in other words.

For instance, if you have a $30 call on Aeropostale, a stock that’s on a long bull run and is currently at $32, you have a good chance of catching more of that trend. But it may be topping. So the question for setting the stop is: What’s a normal setback - an acceptable zig or zag - and what’s the place where the trend is in real trouble? What event triggers my warning to bail?

I might use a traditional point-and-figure chart and set the stop on Aeropostale at $26, where the chart would give a sell signal. Or using a “trading chart” with different parameters, I’d more likely set the stop closer, at $28 - a short-term sell signal.

That’s just one choice. Drawing a bull support line, I’d get an even closer stop, at $30, and still have a technically defensible reason to give up my optimism and cut the trade short.

With stochastics, I’d get out when the line turned from overbought and started falling. With Parabolic SAR, the stop would come at $27.70. Or you could get out when the price fell below the 20-day moving average at $27.85.

If that’s confusing, it’s because technical analysis is complex. For the beginning trader, a trend line is easiest to use. But the point here is not which technical system is most useful right now. The point for today is: If you are not using a mechanical stop, either your advisor or you needs to know enough technical analysis to set a stop where your bull trend turns bearish, or vice versa.

Here’s My Private “Plan C” Exit Strategy

In the long run, I’ve come to prefer using the “event” plan, with technically based stops. The pros are clear. You are exiting with reason - the reason being that your bullish stock stopped being a bull (or your bearish stock stopped being a bear).

The cons are that these stops take more expertise to set, and there are a number of ways to choose. On top of this, stocks on strong trends often do not have clear exit points nearby. That’s the reason a mathematical stop is best for most beginning traders.

What do I do? Plan C…

I have a technical stop backed up with a mathematical stop. I’ll get out when the trend changes or the option falls 50%, whichever comes first. That allows me to stay with trends that are working, without going overboard.

Of course, if you are using an advisory like Karim’s LEAPS Trader, your advisor will make a choice that fits his or her system and guide you right to it. So here’s one immediate take-away lesson for today: If you are using any advisor or considering any service, it should include telling you when to get out.

Good Trading,

Mt. Vernon Research Team

Today’s Smart Profits Cribsheet

Here is the key to having a successful exit strategy: Limiting your losses and letting your winners run. Sounds simple, I know. But you’d be surprised how many people let fear and greed control their decision-making process. But after doubling your money in a particular investment, there is a simple investment strategy that allows you to take risk out of the equation and let your winners run to some spectacular gains. Find out more in Smart Profits #484, Investment Strategy: The Exit Strategy That Nets Big Winners And Reduces Risk.