Options can be used to trade market direction or volatility. It may also be used to hedge risk or to try to generate income. One of the most appealing aspects of buying options is the defined risk in such a position. If you buy a call option on stock XYZ for a premium of $1.00 ($100), no matter what the stock does like, you can’t lose more than the premium paid.
Just because your maximum risk is defined, doesn’t mean you have to lose the entire premium if the trade doesn’t go according to plan.
This simple guide will provide some ideas on how to manage a long option position that is not cooperating.
Here are five ways to figure out when to dump a long option:
- If your market outlook has changed, get out: If you bought a call option because you were bullish on stock XYZ two weeks ago but now today have become bearish, you may want to simply cut the cord. Admit you are wrong and move on to the next trade.
- If a key technical level is breached: If you are long on a call on stock ABC and it breaches a key support level to the downside, you may want to consider getting out. A breach of support could potentially indicate lower prices are in store which won’t do your long call position any favors.
- Use the 50% rule: If you buy an option for $300, sell it back to the market if the premium declines to $150.
- The “time” stop: Options are wasting assets and all inputs remaining equal will lose value as they approach expiration if out-of-the-money. If you buy an option and the expected market move doesn’t occur within a set period of time, you may want to dump it.
- Use delta: If you buy an option with a delta of 50, that option is at the money. If the delta is declining, the option is getting further away from the money and could turn into a loser.
Don’t fall into the trap of watching long options expire worthless. Manage your risk on a long option trade just as you should with any other trade. Decide how much you are willing to risk on the position before initiating it and stick to your plan. Always protect your capital and cut losers quickly. The quicker you can admit your are wrong, the more capital you can potentially save.