Here at OptionsAnimal, students hear this cliché over and over. This is the greatest test of personal discipline! Understanding the options instruments, how they behave, how they combine to take advantage of strategies is only part of becoming a successful options trader.
A critical element of putting it all together is in sticking to your trading plan, whether the trade is moving toward your primary exit or requires that you adjust the position to a secondary exit. The trading plan, which is designed IN ADVANCE of trade entry, is created so that “reason” guides your actions, not emotions.
Look at an example presented by a student this week.
AAPL @ $270.22 September 15, 2010
Jan 2011 Call $300 @ bid 8.15 (short call for credit)
Total Debit => $262.07 (cost of long stock minus credit for short call)
Risk on Trade => $262.07
Cost Basis => $262.07
Max gain => 37.93 ($300 – CB OF 262.07)
ROI = 14.5% in 128 days (annualized to 41.3%)
Enter a covered call on 9.15.10 for a total debit of $262.07.
On October 13, 2010, AAPL broke the $300 barrier. On 10.18.10 (just before earnings announcement) the stock closed at $318.00.
What should you do? Do you feel that you’re missing out on more profit? Should you close the short call so that you can reap a larger gain on your long stock position?
Let’s do some math.
At the end of day Oct 19, 2010, AAPL closed at $309.49. The ask of the Jan 2011 call 300 was 25.40. If we buy to close the short call (SC) it will raise our cost basis (CB) to: $262.07 + $25.40 => $287.47.
What is the new Risk on the trade if we close the SC? $287.47, our new cost basis.
How far will AAPL price need to rise to generate our original expected max gain? Cost basis plus original max gain => $287.47 + $37.93 = $325.40. Where is our target exit, if we close the SC? How much more must we expect to gain (over and above the original max gain) to make the additional risk worth it? (We’ve added $25.40 risk to the trade by closing the SC early.)
We could explore rolling the SC up and in for potential added credit. This may increase our gain and shorten our time in the trade, thereby increasing our annualized ROI. Another adjustment worth exploring is rolling the SC in to a front month at the same strike. The shorter time frame for the trade has a higher probability of meeting our PE while increasing our annualized ROI. And, don’t forget the 50-50 rule adopted by some traders. “When you can grab more than half your potential profit in less than half the time expected to be in the trade… Do It!” Where is this trade today? Showing a profit of $24.70 in only 35 days, or 9.4% (annualized to 98.3%.)
The habit that we promote at OptionsANIMAL is to plan the trade IN ADVANCE. By asking ourselves what we will do if the underlying trends Bullish, Neutral, or Bearish. Giving this careful consideration up front forces us to consider our alternatives and set up trigger points that prompt us to take action. We can leave the emotions of fear and greed out of it, because we have planned our next steps no matter what the market does. Now, we must show personal discipline to Follow Through on the Plan!