Exits to Consider

By: Rob Roy

The following is an excerpt from Rob Roy's Option Axiom Rules Trading Course

Technical Exits

Technical exits refer to points on a chart where the trader would exit the trade regardless of profit and loss on the options.  Once the stock has reached either the bullish or bearish target it would be wise to close the trade – win, loss or draw.  As you develop your skill sets in the marketplace you may find that the movement towards the projected target sets up for a continued trend, or the reversal of the trend.  This would indicate the trade should be adjusted at this point to reflect the new information on the stock.

Profit and Loss Exits

Profit and loss exits refer to the actual value of the options.  It is always wise and recommended to set a loss target on a trade.  This is simply the value of the position the trader is willing to lose before they exit.  Most often this is calculated using a percentage value.  For example, say a trader bought a Strangle for $4.00 and they are willing to lose 50%.  When creating their trade plan they would put in that they will close the position at a loss if the value of the Strangle was to dwindle down to $2.00.  It would be smart to not only put the percentage value you are willing to lose, but the actual dollar value as well.  This saves the trader from having to do the math each day to calculate what the dollar value of the 50% would be.  It is suggested that the loss exit be somewhere in the range of 30% - 50% the value that was paid for the Strangle trade.

Profit targets work the same as the trade makes money.   Some traders would be happy to take 50% - 70% profit on the trade even if it had not reached the projected move, while that is not our recommendation here; there is nothing wrong with doing so.  Keep in mind however, that if the trader is willing to take a 50% loss on their Strangles but consistently exits at a 20% gain they will need to be right on many more Strangles in order for their wins to cover their loses.  This skill set will develop over time as the individual trader learns what their risk tolerance is in the marketplace.

Time Exits

Time exits refer to either specific dates to exit, or at a certain number of days left to expiration.  An example of a specific date in an Axiom Strangle trade would be earnings.  Say there was an earnings event happening during the trade that was two weeks after entering the trade.  If the stock did not move at all on the day of earnings the trader may decide to exit 1 – 2 days after the earnings event if there was not real movement.  The reason here would be the stock may have been consolidating into a wedge pattern in anticipation of earnings.  If the stock did not move, it would be reasonable for the trader to then close the position – win, loss or draw.  Of course knowing whether or not the stock typically moved at earnings would be important.  If the stock usually does not move big around earnings the trader may not decide to trade only the wedge pattern as earnings is not an event for this stock.  If the stock usually did move large on earnings and for whatever reason did not this time around, it would be reasonable for the trader to assume the event is over and close the trade – win, loss or draw.

Using a time exit set to a certain number of days left to expiration can be used to avoid the natural decay of options as they get closer to expiration.  Some traders set to this to 30 days to expiration while others may leave the trade to 20 days to expiration.  The rationale behind this is to avoid the period of time where options typically lose time value the quickest through theta.

 No Movement Exits

There are times when a trader finds him or herself in a Strangle trade where the stock does not seem to be cooperating and moving very little.  With the stock trading relatively flat the options will still experience time decay, losing value each day.  A trader may decide that if they do not see a substantial move within a set number of days or weeks to simply close the trade – win, loss or draw – to avoid the time decay.  There must be a little caution and patience used with this type of exit as stocks may not break out of the pattern immediately.

A no movement exit may also be paired with an earnings event.  If the trader does not see any movement from a stock that typically does move on earnings they may consider closing the trade.

Fast-Moving Exits

Fast-moving exits are used to capture profit in Strangle trades relatively quickly.  An example of this would be a stock chart that makes a sudden directional move up or down in one to a few days without reaching the expected target.  Perhaps in an Axiom Strangle trade the stock moves to 50% - 70% of the expected target in only a few days.  While the trader may still expect the stock to finish moving to the full expected target the stock may experience a pull back from the stock chart before it does so.  It may also move slower to complete the expected target and cost the trader some profit in time decay.

The biggest caution to using this type of exit would be taking the profit too quickly too often.  Beginning traders by nature tend to take profits too quickly and hold onto losing trades too long.  Falling into this trap leads to too many small profits and too many large losses.  There is a delicate balance to this and understanding when to use this type of exit that can only stem from experience (either paper accounts or real accounts).

Size and Scaling Exits   

Size and scaling exits are one of the more advanced aspects to trading plans.  Size and scaling are closely tied to money management (how a trader decides to handle risk allocation or money in their accounts).  A trader may decide that a particular pattern set up may not yet be fully formed or not quite the cream of the crop deciding to trade a smaller size position in the trade.  This thought process is not encouraged for new traders.  Without experience in trading a new trader will not be able to accurately judge the quality of a trade.  This type of judgment will only develop after many trades and experience understanding what the setup is implying, as well as what the overall market conditions may be.

Imagine there is a wedge pattern that meets all of the trader’s criteria.  However, the trader is looking at the stock chart and thinks there could be a little more consolidation in the wedge pattern, yet still wants to have exposure to the set up should the stock break out now.  They may decide to enter in a partial position (or a smaller number of contracts than what they would typically trade) with the understanding that if the stock does continue to consolidate into a better wedge pattern they will add to the position at that point.  This again is not encouraged for beginning traders, as they won’t yet have the experience to make this judgment call.

A scaling exit would be this concept in reverse.  The trader enters into a normal-sized position for their account.  During the trade they reach a decision point according to their trade place.  Rather than closing the entire trade down, they decide to exit a part of their position, locking in some profit while maintaining a position in the trade.  The most common example of this is when a trader reaches a 50% profit gain they exit half of the trade to remove any of the initial risk.  While that seems like a good idea at the onset, what if the trade does not continue to profit, and instead loses?  The trade as a whole could end up breaking even.

Another consideration is rather than taking half of the trade off, closing more than half of the position so that even if the remaining contracts take a loss, the overall result is the trade still shows a profit.  The amount of the trade to close or even leave in play may differ as the trader places a judgment on the valuation of the risk or event causing them to look at scaling.

Trading plans can be as simple or complex as the trader wants to make them.  There is an overlap in many of these concepts, which is normal when creating a trading plan.  Over time and trader experience these ideas will be added, subtracted and expanded upon.  Start simple and add complexity later on.