Entries - position management

Once you have entered a trade, you then need to manage it.  This basically means that you want to watch it every day to see if you need to either get out of the trade, or stay in it.

You would exit the trade for 2 reasons:

1.  The trade hits your target, or

2.  The trade hits your stop

The target exit is simple - the stock price went where you thought it would - mission accomplished.

The trade hitting your stop is the opposite - the stock price did NOT go where you thought it would.  It either went against you, or just traded more sideways and did not hit your target.

Let's talk about STOPS.  

Stops are basically the line in the sand that if the price crosses it, then you realize your trade is incorrect, and you take your loss and get out.  Human nature would want you to stay in the trade and just HOPE that it will turn around in your favor - this has been the doom of many many traders.  HOPE has hurt me many times in the past.  Being strict with your stops will save your account from taking a huge financial loss.

Think of the stop as your friend.  It protects you from further loss and allows your trading account to live another day.  It has been said that the best traders take their losses quickly.

Now, we have to address where to place your STOP.  Look at the chart below:

At the far right you will see the higher low that formed, which is represented by a black candle.  You'll see the next white candle that closed above the high of that black candle (i.e. higher low day).  So, we want our stop just below the low of that black candle.  Personally, I take the lowest price of that black candle and subtract $0.25 from it and that becomes my stop (here represented by a blue line on the chart).  I think as long as you place your stop below that low somewhere, then you are good to go.

The stop is placed below that low because that is where the buyers came in and drove up the price.  If price trades back down to that low and goes lower, this means that either the buyers are no longer there, or that the sellers are stronger than the buyers and the direction of the trend MAY be changing from bullish to either sideways or bearish.

So, now in our trade example that we entered, we have:

1.  The Target = $36.00

2.  The Stop = $30.92 (low = $31.17 - $0.25 = $30.92)

There is one other Stop I usually have active when dealing with options, which is IN ADDITION to the price stop above.  First, remember that options involve time.  And as we get closer to the option expiration date, the more time decay is affecting the option price and is making that part of the option price cheaper.  (again, if you have not gone to other websites for education on this part, then please do it now so you understand this concept).  

So, if we are going more sideways than up toward our target and it's taking a long time, then we don't want our option price going to zero and thereby losing our entire trade.  To combat this, I use a 50% stop on the price of the option I purchased.  So, if the price of the option drops by 50%, then I'm getting out and will cut my losses at that point.

In our example, the initial price of the option was $4.10.

50% of $4.10 = $2.05

Now we have 2 different stops on our trade:

1.  If the price of the STOCK hits $30.92 or lower, then we'll sell our option to cut our losses.

OR

2.  If the price of the OPTION hits $2.05 or lower, then we'll sell our option to cut our losses.

Now we are all set on our managing our trade.  It's either going to hit our target, or it's going to hit one of our stops.  The next post shows what happened.