Many of the trading opportunities are speculative in nature. If you are using option volume, option premiums, or the put–call ratio as a predictive indicator, you are most likely going to take an outright position, as opposed to a hedged strategy. In a broad sense, outright speculative positions are the easiest to manage—you are generally long a security (stock, futures, calls, or puts), and all you have to do for follow-up action is to adhere to some sort of a stop loss. In reality, though, an outright trading position needs more management than that—from initial selection to final sale. In some cases, there is no underlying—sector index options, for example—so options are then the only choice. However, when there is a choice, the only way to logically make it is to evaluate the options with a mathematical model. You must know the relative price of an option before you trade it. If the options are too expensive, you may then decide to trade the underlying instead. In order to decide if the options are “too expensive,” you must have some gauge against which to measure the current option price. That gauge, of course, is volatility. You should compare the current implied volatility of the options to the recent historical volatility of the underlying. In addition, you should also compare the current implied volatility with recent implied volatilities.
Another decision that must then be made is which option to buy. Buying the short-term in the- money option is usually the best choice. The trader obtains leverage because he owns an option, but he does not spend a lot for time value premium. The number-one reason that option buyers lose money is that they buy options that are too far out-of-the money. These options also may have too little time remaining. This mistake can cause the trader to lose money even though the underlying may move in his favor. Whereas with the in-the-money option, he will almost assuredly make money if the underlying has a favorable move. As for actually buying the position, be careful about using market orders in options unless (1) you are trading a very liquid option, or (2) you are placing a small order. Otherwise, limit orders would serve you better in the long run. You may find that you can often “split” a market (i.e., buy between the bid and the offer), especially in a moderately active option. Don’t be stubborn about using limits, though. If you are attempting to buy a very thin (illiquid) option, the market makers may just raise their offer when they see your bid, for they don’t really want to take a position.
Risk management, through stops, of an existing position is another important factor, especially in speculative trading. Not only must you adhere to a stop loss of some sort, but you should also have a plan for taking partial profits at times along the way. Set the stops based on technical support and resistance levels in the chart of the underlying security. Some traders who buy options set stops based on the option price; this can mean that time will stop them out or that they sell their options when the underlying is sitting right on a support level—not a good idea. However, when they are trading in-the-money options, they don’t have to worry about time decay so much, so they can use the underlying’s technical levels to place their stops. If you are trading options, use a mental stop; if you are trading stock or futures, you can use an actual stop. A mental stop means that you don’t actually have a stop-loss order on the floor of an exchange; but when the underlying hits your mental stop price; you can evaluate the situation at that time. If it seems that the position should be sold, then you can decide on a market or limit order. In general, if your mental stop has been violated and if the stock or futures contract seems to be headed in the wrong direction, a market order is best. However, if the stock or futures seem stable, you might try to use a limit order to exit the position.
Perhaps even more important than limiting losses is managing profits. Everyone wants to follow the conventional wisdom to “limit your losses and let your profits run.” Actually doing this is easier than it might appear, despite conventional wisdom to the contrary. Most traders know the anguish of seeing a position move in their favor, thereby generating an unrealized gain, only to have it fall back and stop them out. To me, this is far more devastating than taking a profit too early, although we can attempt to get the best of both worlds. There are two ways to do this: (1) take partial profits and (2) use a trailing stop. Some traders take partial profits on a strict basis. For example, if they own options, they may sell a part of the position if they get a 25 percent profit. Then they would sell a similar portion if they get a 50 percent profit. Then they would attempt to hold the remainder with a mental stop. Other traders prefer to take profits based on the underlying’s action—if it hits resistance or spurts ahead too fast, they take partial profits on their position. In either case, this is the correct approach, for it allows them to take some realized gains but still lets their profits run. The other technique that protects profits is the trailing stop. Once a position begins to move in your favor, raise your stop price, whether it is a mental or an actual stop. Initially, you use a fairly tight stop in a trading position. But, if you are taking partial profits along the way, you might not want to keep the trailing stop as tight when you raise it. That is, when things are going your way, leave some extra room for a small correction to take place without stopping you out.
To limit your losses, set a reasonable stop to begin with and have the discipline to adhere to it. Then use the trailing stop to let profits run. Don’t be lured by targets, and don’t fall prey to your emotions when profits are building up. Targets don’t do anything except get you out of a position that is about to make a long run. Staying with one or two super-trending trades a year can make all the difference in the world. Closing stops are also easier for traders who might be employed in another profession. All you have to do is check where your stock is trading with about 10 minutes to go in the trading day. If it has violated your stop, then exit your position. Or if you miss the close on any given day, then see where the stock closed and exit on the opening the next morning if the stop was violated. There are variations on the type of stop that could be used. Chandelier stops and parabolic stops are designed to “hug” the current price more closely if a very strong, parabolic-style move develops, and they incorporate the recent volatility of the underlying. But the real point is use a trailing closing stop. In summary, some axioms are difficult to accomplish—such as “buy low, sell high”. But cutting your losses and letting your profits run is something that everyone can accomplish without much difficulty, merely by setting an initial stop to cut losses if necessary. Then, if profits develop, using a trailing stop to let them run.