You probably know you should have a trade plan in place before entering an options trade. But what does that really mean? Here are a few ideas for creating your own trade plan, along with some of the order types you can use to implement it.
Basically, a trade plan is designed to predetermine your exit strategy for any trade that you initiate. That’s pre-determine, as in, before you actually make the opening trade. If you make your trade plan in advance, your overall approach is less likely to be influenced by the market occurrences that can, and probably will, affect your thinking after the trade is placed.
Plan Your Exit Strategy
There’s no one-size-fits-all trade plan, but at the very least, consider planning your exit points based on a certain profit target or specific loss tolerance.
For example, suppose you bought the XYZ January 80 call for $3. You may want to set exits based on a percentage gain or loss of the trade. Using percentages instead of dollar amounts allows you to treat your trades equally. For example, some traders will exit option trades at a 50% loss or a 100% gain. So that’s their basic plan, at least on paper.
Exiting with a profit of 100% would mean selling the January 80 call for $6. If the price were to happen to go over $6, you’d get your original $3 back, plus $3 more, for a 100% return (less transaction costs). Exiting the trade with a 50% loss would mean selling the call if it drops to $1.50, which is half of the entry price.
Exit Order Up
Next, you can place the orders that would close out the trade according to your plan. The profit exit could use a basic limit order to sell the calls at $6. The loss exit could use a stop order (also known as a “stop-loss” order), which specifies a trigger price to become active, and then it closes your trade at the market price, meaning the best available price.
In this example, you would set a stop order at $1.50. Once the call option drops to $1.50, the order activates and the option is sold at the market price. Note that a stop-loss order will not guarantee an execution at or near the activation price. No one knows exactly where a market order will fill. It could fill close to $1.50 or very far from that price. Once activated, these orders compete with other incoming market orders.
You could place these two orders together using an OCO order, which stands for “one cancels other.” Once either order gets filled, the remaining order is canceled automatically. The OCO aspect is what would allow two seemingly conflicting closing orders to be in effect at the same time.
FIGURE 1: EXIT ORDER STRATEGY.
To close out an existing position in the thinkorswim® platform from TD Ameritrade, right click on the ticker symbol (or anywhere on that line) to pull up your order options. Fill out the quantity and price fields, and click Confirm and Send. For illustrative purposes only.
This same logic could apply to a bearish trade on XYZ. Suppose you paid $4 for the December 60 puts. You could try to close the order at a 100% profit (minus commission costs) by placing a limit order at $8. Or try to close them with a 50% loss by selling them with a stop-loss of $2. Keep in mind that the stop-loss order doesn’t guarantee you’ll get the trigger price. And, again, an OCO order might be useful for entering both orders.
Trail to Manage Risk or Profits?
Another option order type to consider is a trailing stop order. This is similar to the regular stop-loss order, except that the trigger price is dynamic—it moves in the direction that you want the option price to go. If a stock or option price moves in your favor, the trail stop adjusts up for a long position and down for a short position, it gets closer to triggering if up and down price movements have been taking place.
FIGURE 2: FOLLOW THE TRAIL; FOLLOW THE TREND.
For illustrative purposes only. Past performance does not guarantee future results.
Let’s say that with the January 80 calls, instead of using the stop-loss order to cut your losses, you use a trailing stop-loss order of $1.50. This means the trigger price will be $1.50 lower than the highest price the option attains. If the option moves up to $5, then the trigger price will become $3.50 ($5.00 – $1.50). Stop-loss orders can be used to try to lock in a profit rather than limit a 50% loss. If you hold a position that currently shows a profit, you may place a stop order at a point between the purchase price and the current price as part of your options exit strategy.
These option order types work with several strategies—on the long side as well as the short side. As a short example, let’s say you sold a November 50 cash-secured put on XYZ for $2. On the profit side you could enter a limit order to buy the puts for $0.05. Although you wouldn’t receive 100% of your profit potential, closing the put eliminates the risk of remaining in the trade and may free up capital for other trades.
The exit trade on the loss side could be a stop-loss order to buy the puts if the price rises to $3, which would exit the trade with a loss that’s about 50%. Or you could use a $1 trailing stop-loss order. So if the puts dropped to $0.75, for instance, the trailing trigger price would be $1.75.
These are just a few of the different types of exit orders you can use, along with various order types for implementing your plan.
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