Sponsored Link:
Trailing Stops
The Smart Profits Report: Issue #133
Tuesday, August 10, 2004
Trailing Stops: How to Give Your Options Room to Grow
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
In my 20-plus years of trading, I’ve found that most investors face two problems when it comes to trading… They don’t know when to pull the trigger on the buy side or on the sell side. When shares move down, the normal reaction is to freeze… and acts like this can’t be happening. When shares move up, the euphoria of an early retirement seems to take over.
Of the two problems, though, the one that causes the most alarm is deciding when to sell your investments when they’re headed down. One way to take the pain out of such decisions is to use a system of trailing stops from day one.
Here’s how it would work…
Trailing Stops: Choose the Risk That’s Right for You
Let’s assume that your tolerance for risk is low, and you set a 10% trailing stop. If you bought an option for $1, you would sell if the price fell to $0.9. Simple, right?
You’d also make a daily adjustment to your stop price, based on the where the shares close. So if the options moved up to $1.20, then your new stop would be $1.08. You would consistently take 10% off the closing price, and use that as your guide, as long as the price is increasing.
Of course, this can be a bit of a pain. Your broker won’t do this for you, and unless you are glued to the computer screen, you won’t be able to do this either. You’d have to use a “mental stop” and keep your trigger price in mind… either that or you’d have to continue entering new limit orders and running up huge commission costs, which is impractical.
Nonetheless, here’s one real-world solution…
How to Give Your Trailing Stops Room to Grow
A couple of weeks ago I recommended that my LEAPS service members take advantage of the falling Nasdaq index by buying puts on the Nasdaq QQQQs. Our timing was good. We made about 40% on the trade in two weeks as the Nasdaq fell almost 6%.
But I didn’t know for certain in advance that it would turn out so well. Even the smartest trades can turn the wrong way, so I planned ahead for potential trouble. When I recommended the puts, they were at $1.75 and I set a stop-loss at $0.80 from the start.
Why such a big trailing stop?
With options (much more than with stocks) you don’t want to set such a narrow stop loss that you get stopped out without having the chance to make a profit. Options can move 10% in a day, in either direction. Sometimes that happens without anything changing to the underlying stock.
And with Long-Term options like LEAPS, you have many months, even years, to make money. So setting a fretfully tight stop loss defeats the purpose of using the time available and going with the stock’s longer-term trend.
And, with LEAPS, the spread between the bid and offer is often quite large (5% to 15% in some cases), so that a tight stop would cause an almost immediate loss.
So what’s the solution?
Start Loose, Then Lock ‘Em Up
So here’s what we did with our profitable QQQQ trade. As the option increased in value, I moved the stop loss higher along with it. Each time our option made a significant move, we increased our sell stop.
For instance, when the option hit $2, we moved our stop from $0.80 to $1.50.
Why such a jump? The answer is protecting profits. At that point the trend was moving in our direction. You want to follow your profits upward, but you must also realize that once a trend slows down and brakes, it usually means a new, opposite trend may be forming. So as you begin to make money it makes sense to use narrower stop losses to protect your profits.
With such a good trade, we moved up our sell stop to preserve our capital several times. When the option moved up to $2.50, we moved our stop up to $2.20, locking in a nice profit in case the trend turned. When the option then moved to $3 - definitely confirming the trend - we stayed with it, but moved our stop up to $2.40, locking in a 40% profit. The next day the market turned and the Nasdaq rallied. We were ready and I issued a sell, getting out a little higher than our sell stop.
As for relying on your broker to maintain a trailing stop for you… hardly any will do it… unless he or she has a number of clients trading the same options.
Good Trading,
Karim Rahemtulla
|
Today’s Smart Profits Cribsheet
- For more on option terms like “trailing stops,” “put options” or “LEAPS,” see the Smart Profits Glossary.
Related Articles:
- Time Stops Strategy: Your 10-Day Profit Test
- Exit Strategies: Prenuptial Agreements for Options
- Using LEAPS: These Options Are Set to Run Full Tilt
