Discipline in trading: Setting exit plans before placing a trade
Developing a detailed exit plan is a key step before placing any trade. Whether you are buying a stock or trading options, it is imperative you have a written plan on to manage the trade in the future. Of course we need to know what to do if the trade works but more importantly we need to work out what to do when things go awry. This is a key step in the OptionsANIMAL methodology which helps us to maintain discipline when trades run wild. Here are some important considerations for exit planning before placing any trade.
The first consideration is what we call the Primary exit. Basically what will we do if the trade works as expected? At what point will be have enough profits so that the trade may be closed? Use of variables like movement in the stock (Delta), passage of time (Theta) and changes in implied volatility (Vega) help us visualize how the trade will perform in the future. Setting a Primary exit is useful in keeping the emotion of greed in check. The last thing we want to have a nice profitable trade turn into loss because we waited too long and things changed. It is also acceptable to have more than one primary exit.
For example, I did a 10 contract Bull Put option spread (Feb13 $77.50/$72.50) on Caterpillar (CAT) in our Weekly Animal Trade section on Dec 7th. The stock went up making the trade profitable so I closed it at the Primary exit on Dec 18th for a profit of 6.6% in 11 days. The stock started to fall later in the week and I would have given up some of my profits had I stayed in the trade longer.
Now we consider how we will make money if the trade does not work as expected. This is called the Secondary Exit. We use appropriate call and/or put options to change the direction of the trade as conditions and expectations change. Remember that low probability events happen all the time in the market. It is important to anticipate what might happen in the future and to have detailed, written exit plans. Think about the process of driving a car. When a right turn comes up, we turn right. We don’t hope and pray for a left turn. We have control of the car and turning right leads to a predictable result. Our process is very similar to the experience of driving. We care about reaching our destination safely, and not so much whether we took left or right turns to get there. Here are things to consider for secondary exit planning:
- First, we need to understand what has changed. The trade is not working as planned so something must have changed versus the original expectation. Maybe we wanted the stock to go up but it is going sideways or down. This may be happening due to a change in fundamentals (ability of the company to make money or pay debts) or a change in technical analysis (charts, patterns and indicators) or maybe a change in macro-economic conditions that is affecting most stocks (like a crash in the market). Understanding what has changed and its severity will help us to develop a new expectation for the future.
- Now we consider which options and how many contracts will be required to adjust the trade to the new trend. It is common to have several adjustment choices in a trade. In the CAT trade above, had the stock gone bearish, there are at least three types of adjustments that may be attempted. Which one to choose will depend on the situation, the type of stock and the market conditions overall. For example, CAT may drop on bad news and have room to fall before getting to a technical support. The market may be pulling back at the same time requiring a certain type of adjustment. On the other hand, CAT may be dropping on just short term profit taking because it had run up a lot and there is no bad news…this may require a different adjustment or no adjustment at all right now. Why the stock is falling and the severity of the cause guides us into making the appropriate adjustment.
- Sometimes the reason for the stock movement may not be clear. It is useful to consider scaling into an adjustment. For example if we need to make an adjustment of adding 5 x contracts of Long Puts, maybe we add 2-3 now and wait to add the rest later. This may also be applied later when these Long Puts are no longer needed…instead of selling all of them at once we may sell them over time.
- The next thing to consider is what to do after the first adjustment is made. We will be in a new trade which will need its own Primary and Secondary exit plan. In fact, the choice of the first adjustment will be partially based on the ease of the second or third adjustment, if required in the future.
- Finally, as part of good portfolio management, we need to carefully consider our cash position. Will adjustments we make in the future require cash or will they bring in cash to our account? What if several trades required adjustments at the same time? Appropriate levels of cash or buying power should be maintained depending on the types of trades in the account and your trading style.
If all this sounds like a lot of work consider the alternative. Most traders only make money when their predictions come true. With careful planning before placing a trade, you can learn to make money even when your original expectations do not come true. Further consider that once you master exit choices for a particular strategy, say a Bull Put, you have learned it for all the Bull Puts you will ever do. The “work” becomes less and less demanding because you have done it before and know how the process unfolds.
It is a fact that we cannot predict the future accurately. Markets, stocks and your trades are dynamic. New information can come out at any time and change the direction of your stock. Having pre-determined, written exit plans may allow you to navigate your trade to profitability and maintain discipline, even when your initial predictions fail you.
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