Option traders spend so much time finding a trade that they neglect to think about maybe the most important part: the management of the trade. Sometimes the thrill of finding a good-looking trade overwhelms option traders and all they can think about is hitting that enter button on their platform. Once the trade is on, then they start to think about all the money they are hopefully going to make. Many option traders don’t take the time to stop and think about what is going to happen in the future, especially if the trade doesn’t perform the way they had hoped.
For example, I was on a webinar recently talking with attendees about Bank of America. There are plenty of traders who got long Bank of America a couple months ago who are now scratching their heads wondering what to do since the down turn. They should have had a plan
A simple way to combat this problem is by having a plan in place before even entering the trade. This goes back to the psychological part of trading. Having a plan in place will remove emotions from getting in the way of decision making and possibly producing unwanted results. Should I stay in the trade or should I exit? Decisions like that should not be made in the “heat of the battle” because many option traders can become too emotional when the trade is in progress. Here are a few components of the trade management plan option traders should think about when writing a plan:
Option traders should think about how they are determining their targets. What should a good target be? How many targets are there going to be and how close to the target is considered to be reached? The plan should also have something addressing the issue about what to do if the target is reached and not filled. What about if the target is exceeded? A plan needs to be put in place in case that scenario rises especially since stocks will gap from time to time.
Another benefit from picking your targets in advance is once option traders review their trades, they can determine if they are being too conservative or too aggressive with their targets on a general basis.
Option traders should also think about how they will exit if their targets are not met. How will the exit or stop be determined? There are a variety of ways that can be chosen like a pre-determined risk amount, support or resistance on the charts, a bar-by-bar (candlesticks) method just to name a few. With options there is a time component unlike equities so option traders might want to put some type of time exit in place as well. An example would be that the trade will be exited after 20 days even if a target or an exit stop has not been reached.
Remember the primary goal of any trader is to protect your capital. Having targets and especially stops in place will benefit every option trader and help remove emotions from trading. An option trader needs to know exactly what he or she will do no matter what happens during the course of the trade before that entry button is pushed.
— Dan Passarelli