Here’s part of my investment philosophy (You can read more of it here.)
When initiating a new position most investors recognize the importance of placing a trade that they believe will produce a profit. Those who understand the importance of managing risk also understand the risk required to earn that profit. When you are satisfied with both the reward potential and possible loss for a given position, then you are within your comfort zone.
It’s also important to remain within your comfort one as the trade progresses and time passes. This is the point that many traders miss. They mistakenly believe that if the position is acceptable when opened, that they don’t have to do anything until the options expire. That is a dangerous way of thinking.
If market conditions change or if the price of the underlying stock (the stock tied to your options) changes, it’s possible that the position (let’s assume it’s a spread) exits your comfort zone. This can happen when:
- The spread becomes very profitable and there is little potential profit remaining. It’s great to have done well, but when holding the position until expiration can only earn a small additional profit, the risk of holding becomes too great because the reward potential is too small. If the stock makes an unexpected move, the profit you earned can easily disappear. Don’t try to collect every last nickel on a trade..
- The underlying stock makes an unfavorable move and another such move would result in a substantial loss. If that potential loss is more than you can afford to lose, thenthe risk of holding and hoping that the stock reverses direction is too great – and closing (or otherwise adjusting) the position is the wisest step you can take.
Comfort zones should be flexible as you gain more experience trading options. That does not mean taking on more risk, but it does mean that it’s appropriate to change your basic methods as market conditions change. For example, bullish strategies such as writing covered calls may make you uncomfortable (for good reason) when the market is bearish and you may prefer to trade iron condors instead. That’s why it’s a good idea to be aware of alternative strategies, even when you have no immediate intention of adopting any of them. They become part of your arsenal of useful trading tools.
- Dr. Brett Steenbargen, whose expertise is trading psychology, makes this point very well in his trading blog (dated May 17, 2008) “It’s difficult to succeed at trading, but–given rapidly changing market conditions – even more difficult to sustain success. It’s not good enough to find winning trading techniques; one has to continually adapt these techniques to an ever-changing environment.”
- Jeff White, in his blog espouses a similar philosophy for day traders.
Definition: Spread – A position consisting of two or more options on the same underlying stock. One option hedges (reduces the risk of holding) the other. Example: buy one call option and sell another call. This strategy limits gains, but more importantly, limits losses.