Learn how to manage a losing trade

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Even when using option strategies with limited risk, such as covered call writing, there is no point in allowing losses to reach that limit.

Reducing risk, adjusting trades, and exiting losing positions at the right time are essential skills for the successful trader. If you cannot recognize and limit risk, and if you allow losses to run in the hopes of getting back to even, then there is not much chance that you will last very long as a trader.

So let’s take a look at how to manage a covered call and the alternatives to consider when the position has gone south.

Example:

Say you own 400 shares of XYZ. The original cost is immaterial, but you paid $42 per share, and the current price $38.

Earlier, you sold four XYZ July 45 Calls (again, the premium no longer matters) at $1, and the current price is 10 cents.

A trader who has not yet learned to manage risk might say: “This stock was a poor investment choice. I’m not really sure why I bought it, but it doesn’t matter. This position is losing money, and I am not going to take the loss. I’ll wait. After July expiration, I’ll sell another call and recoup some premium. After I do that a bunch of times, I have a good chance to get back to even on this position.”

On the other hand, a trader who understands risk management might say: “When I bought this stock, it had support at $38, and I expected the stock to move to the upper $40s. It seems that I was wrong. The stock has traded down to its support level, and if it moves any lower, I am going to take action to prevent getting hurt. I have two suitable choices:

1. Sell my 400 shares and buy back the XYZ July 45 Calls. Take my loss and move on. I would never leave those calls outstanding. All I can gain is that last 10 cents per share, and the potential loss is large.

2. Buy! the XYZ July 45 Calls, paying that 10 cents and write the XYZ Sept 35 Calls. The call price ($6) looks pretty good, and the stock has another support level just above $35. I assume this trade would lock in a loss, but I never pay attention to that. My energies are spent in finding good ideas for making money from my current position, and that means tomorrow and beyond. Writing the XYZ Sept 35 Calls offers that profit opportunity [stock is $38; if assigned later, I sell at $6 plus $35]. I still want to own this stock.”

The poor risk manager closes his/her eyes and hopes for the best. The better risk manager has a reason for owning the stock now, and has a viable plan if the stock breaks support.

The oft-used trade idea of buying back an inexpensive option (sold earlier) and moving the short position to an option with a lower strike and a more distant expiry is a technique known as “rolling the position.”

I can provide other examples, but the general principle is what’s important: Don’t avoid thinking about losses. Take an active role when managing the risk of any position, regardless of which specific strategy is being used.

“Active” does not refer to making frequent trades. It refers to being aware of the position and its current risk and reward potential. Most of the time, the “active” part of managing risk is the decision to do nothing — because holding is the correct decision at the time. However, when that is no longer the best choice, you must be aware of that fact and act accordingly.


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