Hear JJ Kinahan, Chief Market Strategist at TD Ameritrade, and guests discuss option exit strategies that are designed to help minimize risk.
JJ: This is Understanding Options. I'm your host, JJ Kinahan.
Victor: Hello everyone, I'm Victor Jones. Welcome to TD Ameritrade chief strategist JJ Kinahan's podcast series, Understanding Options. Today, JJ and I are joined by Scott Connor and Kevin Hincks from TD Ameritrade and, of course, Tom White, from our affiliate advisory service, TradeWise.
JJ, how are you doing?
JJ: I'm great, Vic, thanks for being here today. And, of course, welcome to Kevin, Scott, and Tom, and thank you guys for being here today to discuss our topic of the day, options exit strategy.
Victor: That's right. Getting into a position is only half of the story. In some cases, maybe not even half. The more important point is, really, knowing how and when to exit a position. So what suggestions do you have, JJ, for exiting positions?
JJ: Well, it's easy to get into positions, Vic, as we all know. Getting out is actually what separates the good from the bad. But the best suggestion I have, and this is before you place the trade, what is your objective? Especially when you're going to trade options. Where are you going to get in? Where are you going to get out?
Too many investors simply buy shares and hope the market moves in their favor. They don't have a specific exit price in mind. And it really makes us have a target price for selling the stock on the upside, and more importantly, on the downside. Where are you getting out if things don't go your way? You can always change this target price if you need to, but you should always have this in mind before you make the trade. The same concept holds for trading options. If I enter at price x, I should have a plan to exit at price y, and at price z to the downside.
So, again, I always know what my plan is when things go really good, and unfortunately, if things go bad.
Victor: Yeah. You always hear, you might hear the term-- analysts out there, they have certain price targets for stocks over a long term. But even traders, having a short term price target, which is great, and, obviously, useful for both investors and traders when buying stocks, obviously. I love this, when you see somebody and their advice is, you want to buy low and sell high. Yeah, we get it, but it's a little bit harder than that.
But with options, it's not always as straightforward as just buying low and selling high. There's different ways, you can do the opposite, or look for neutral moves, as well. So, Tom, what should investors understand when establishing exit rules on options? Not talking about stocks, but options, compared to stocks?
Tom: Yeah. You make a great point. Because options involve a lot of variables, whether it's volatility, whether it's price action, probabilities, and duration. Remember, we haven't talked about that much, is that options are finite. It's not like buying a stock and holding it for 10 years. Options have an expiration date, and investors need to realize that when getting into positions.
I think the biggest thing that you can look at when doing option strategies is that time decay is one of the variables that affects option pricing, right? You buy that option, you buy that call option that we used as an example, you pay a specific dollar amount for that. The value of that option decreases on a daily basis, all things else unchanged. So you have to remember that. If you're selling options, if you're selling a vertical spread as a directional trade, remember that the price of that vertical that you sold and collected a credit, let's just use an example of $1 credit, that loses value in your favor every day, because you sold it, and that's the maximum that you can gain on that particular trade.
One thing we like to tell our clients and teach our clients, is trade management. It's really important when using options. Because the markets are dynamic, and things can change. So one thing we always try to do, if a trade's going against us, or in our favor, maybe it's 25%, maybe 30%, we'll get out of half of that position that we have on, and hold the rest, if we still believe that the underlying symbol is going to go in our direction. So you have to remember that. Reducing risk at every point is a great way to kind of manage positions as you're going through options and how their pricing is affected on a day to day basis.
Victor: Yeah. And, obviously, liquidity is, obviously, pretty important as well, right Scott? I mean, there's no guarantee that you're going to be able to get out of an option, or to be able to close it prior to expiration. Perhaps it's just not liquid enough, right?
Scott: Oh, absolutely, Victor. It can oftentimes be a rare case, but let's say, for example, a call option that has a strike much higher than the stock price, and is near the expiration. And now, as a result, there is no bid for that particular option, or that call option. This can happen if stocks see a big, sudden, unexpected move, or an unforeseen move. If that does happen, and you're still holding that option, that option might have what we call a zero bid, Victor. In other words, there's no one even willing to bid anything for that call, because they figure there's not much chance that that stock is going to come back. So, for us, we really can't even close that one because you can't sell an option for zero.
JJ: It's funny, I think it's a great thing, and again, this is something we've all been guilty of, at some point in our life, is you buy something. It goes your way. Maybe you bought it for $1, it's a $3 bid. You're like, no, this is going to $10. And so, even though your original goal might have been to get out at $2, and the next thing you know, you're looking at it, and there's no bid because it's gone back the other way. There's an old analogy, bulls and bears make money, and pigs get slaughtered.
So, really, thinking about how you can sort of segue out of it makes a lot of sense. And, remember, the greater your return that you are expecting, there is a greater potential you're going to lose your money. There's a definite corollary between how much you risk and how much you can make.
One of the things though that I think people often get stuck in, and we've seen it a million times, and Kevin talked about it in one of our previous podcasts, is, a stock's trading $23, so you buy that $25 call. And the stock moves up a little bit, slowly, and slowly, and gets to $24. And meanwhile, your call went to zero. And you can't understand it because the stock went your way.
One of the ways I try to avoid this is when I buy things, I like to buy things that have some value. So if we're trading at $23, I might want to buy the $20 call, because I know it has at least $3 of value. So if that does go up, I should, theoretically, make some money, at some point, on that. And when I sell things, I sell things that are out of the money. So, buy value, sell junk. You sell things with less than a 50% probability of being in the money at expiration, you buy things with more than a 50% probability of being in the money at expiration.
Victor: And, I think, the example you just said, JJ, the thing that stuck out to me was just, basically, the discipline. You buy something at $1 hoping for $3, and then you start to get a little bit greedy. So, Kevin, I'm curious, what are some tools that you use to help you maintain that discipline with your exit strategy?
Kevin: I think it's all about a thought process right? Like, a great trader enters a room, first thing he does, he looks how to get out of that room if something happens, right? So that's the way I think about trading, just like I think about that. The easiest way, let's say you sell a vertical spread at $1.50. And your target is 80%, right? Well, put in a $0.30 bid to buy it back. Put in a limit good-till-cancel order. Boom, in. Exit already done, exit strategy set, right? Now, that's an easy one, right? If you like 80%, if you like 70%, if you like 50% profit, stick to that. Just get a set plan, and stick to that.
But, the other thing is, we talk about stop orders. And we don't always recommend stop orders, but if you're someone that can't sit in front of the computer all day and trade, then stop orders are a good tool. They'll help you with that risk mitigation that we talk about. Because some people, who are full time investors, can sit in front and they can pick, it's time to get out. Well, if you're working all day, you may not see what the market's doing. So use all the tools, all the conditional orders that TD Ameritrade offers.
Scott: And Kevin, just to add to your comment is, you talked about knowing your exit strategy, and knowing what your risks are. Stop orders can be a little tricky, right? So, in other words, if a stock has a big move overnight, your stop order gets triggered, but guess what? It gets initiated on the opening, and that price could be quite a bit lower than you expected. So what can we do? Well, one of the things we can do is look at using vertical spreads. Because I like to think of vertical spreads as like selling a put, for example, at a lower price, and then buying another put lower, to get that protection. So, in effect, that vertical spread has a built in stop order, if you think about it that way. So, again, another technique that just adds to what Kevin was saying.
Kevin: Using a vertical spread is, in essence, selling an option with a stop order, because it defines the risk. Once you get to that point, that's as much as you can lose.
JJ: Or buying. I mean, it's goes both ways.
Kevin: Same way, right.
Victor: And then order types, of course, are a big one, right? Knowing that you mentioned stop orders, and limit orders, market orders. I think a lot of people, a lot of listeners, might already be familiar with some of those basics. If they're not, there's obviously great information available for people to look at and understand on the TD Ameritrade website. JJ, coming back to you. Are there any exit rules that have helped you over the years?
JJ: Yeah, I think the number one thing, and these guys both mentioned it, before you make the trade. It's really important to define this before you make it, that will help you most of all. And I think doing spreads helps a lot too because it keeps you disciplined.
Let's face it, that the thing most of us face in life that we're all not good at is discipline. I mean, I could walk past Oreo cookies if I had discipline, but I can't. That's why the diet industry is a billion dollar industry, most people are not disciplined in what they do. So, really, helping yourself be as disciplined as possible is great. And it's taking a position at one price, and have a realistic target for where you get out. I think that will really, really help you.
And the other thing is, once the target's hit, good or bad, getting out of the position, and then not worrying about it. Not thinking, what if? What if I'd done this? What if I had done this? Well, if you're going to do that, you're going to what-if yourself to death, and you're never going to make another trade. You just gotta get, here's the thing, boom, move on to the next trade. The great thing about the market is, it's almost like playing baseball, there's a new game every day. Well, there's a new trade every day, there's new opportunity. Don't get caught up on stuff that doesn't matter, so to speak.
So, with all that guys, I'm going to wrap it up, if you don't mind it. It was another great discussion. Tom, Scott, Kevin, thanks, Vic, as always, thanks for keeping the conversation moving. You can also find more education at essentialoptionstrategies.com.
As always, you can find me on Twitter, @TDAJJKinahan. And our biggest thanks goes to you, our listeners. We love doing this, thank you very much for tuning in to us today. And with that, good trading, everyone.
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