Yesterday, I told you that controlling your risk and managing your losing trades was an important part of trading – keeping your costs down is just as crucial to your success as harvesting profits.
Today, I want to talk to you about managing your winners.
Especially ahead of today’s 2 p.m. Fed announcement that could rock markets – big.
You may not think that your winning trades require a lot of hands-on attention. And they often don’t – when everything’s working the way it should, your winners are the easiest trades in your portfolio. You enter the trade, everything goes according to your trade plan, you get out at your profit target, and ring the register.
But sometimes the markets have other ideas…
Regardless of what your goals are – be it a 100% return, a $500 cash payout, or some other profit target – there will be times when you have to take the trade off earlier than you planned.
As many of you know, I always look for trades that will double my money. But this week, I have decided to close out some trades earlier than wait around for that 100% return.
Manage Your Winners
Managing winners is all about controlling risk. A given trade’s risk profile changes the more profitable that trade becomes.
For example, let’s say you buy an option for $5.00. And let’s say the value of that option doubles, and is now worth $10.00. Your risk/reward ratio is now drastically different – you have far more at risk now than you did when you first entered the trade.
Once your trade becomes a winner, you’ve got to protect your profits. There’s nothing worse than watching a winning trade roll over and turn into a loser.
One way to manage your winners is by using a stop loss, a useful tool for limiting your losses. As many of you know, a stop loss is simply an order to sell a security at a specific price. Traders can use either %-based stops or $-based stops depending on their individual goals.
And if you use trailing stops, which adjust as the trade moves in the direction you want, you can limit your losses while protecting your profits at the same time.
But stops aren’t the best strategy when you’re trading options. Options prices can move quickly once the underlying stock starts to rise or fall – and in fact we take advantage of those moves to harvest profits quickly when things are going our way.
If you’re using stops on your option positions, the markets can pull you out of a trade before it’s had time to work. That’s nearly as bad as a winning trade rolling over.
Pay Attention to the Markets
As much as we like those fast moves when they’re giving us profits, we have to be on the lookout for things that might turn our winning option trades against us. That could be the release of the latest jobs numbers, news out of China or the Eurozone, an earnings announcement… really anything that could impact your open trades.
Or it could be today’s announcement from the Fed’s Open Market Committee on interest rates. If the Fed decides to raise rates today – or says anything the markets don’t want to hear – the markets could tumble. The markets have been known to react swiftly and immediately to announcements from the Fed, and the resulting wild swinging market action can wreak havoc on option premiums.
Trades that were profitable become less profitable, or they become trades that have a loss. Either way, those situations aren’t ones I like to be a part of. So the obvious way to get your money out of harm’s way is to lighten your load a bit as the Fed meeting approaches.
There is too much uncertainty on what the Fed is going to do this week. There is always some level of uncertainty with the Fed, but this week there’s even more. Some recent economic data has some analysts suggesting that the Fed could very well raise rates… of course, that same data can be used to build a case that the Fed won’t raise rates.
It’s just too close to call at this point… which is why we want to cash in some of our winning trades now, before the news hits the markets.
Let me show you…
Case Study: The Coca-Cola Co.
Thanks to the Fed’s looming decision, I recommended that my Money Calendar Alert subscribers close down a couple of trades early rather than leave them open… and risk turning winners into losers.
I’m going to walk you through one of those recommendations to illustrate this point. Here’s what happened with our bullish call options on The Coca-Cola Co. (NYSE:KO).
Our KO trade was intended to allow us to avoid the market’s volatility following the ugliness of August 24, when the Dow shed over 1000 points in early trading. At the time, KO hadn’t been correlating with the markets – it managed to avoid a major haircut when the markets were crushed – and Money Calendar saw a bullish short-term future for the stock.
Here’s what I wrote at the time:
Today we’re going after The Coca-Cola Co. (NYSE:KO), a stock that hasn’t correlated with the overall markets, meaning that its trading action didn’t match that of the SPY. That means we don’t have to rely on the Dow to boost an individual stock.
It also means that we don’t have to worry much about bear markets dragging down a perfectly good stock. Today’s recommendation largely sat out yesterday’s volatile action.
In fact, KO hasn’t correlated with the markets for the last couple of weeks. But Money Calendar predicts bullish action for KO.
Here are the instructions as they were delivered to subscribers on August 25:
Entry Date: August 25, 2015
BUY-to-Open: The Coca-Cola Co. (NYSE:KO) KO September 18, 2015 $35 Call (KO150918C00035000) at $3.50 or less.
The trade was filled at $3.49. As usual, our profit target on this trade was 100%.
Here are the exit instructions as they were originally written up:
Action to Take:
SELL-to-Close: The Coca-Cola Co. (NYSE:KO) KO September 18, 2015 $35 Call (KO150918C00035000) at 100% or better.
Our original exit date was scheduled for September 17, but I didn’t want to risk staying in the trade beyond today’s Fed meeting – because any news could spook the markets and cause stocks to fall, turning this winning trade into a big loser.
If the trade is not working, you just have to take what you can get and move on.
So I placed an order to get out of the trade yesterday and ended up out of it at a closing price of $3.58.
Now you may say, but that’s only a gain of $0.11 per contract. And that’s true… but when the Fed announces tomorrow and the market goes crazy in response, and KO suffers a loss, I will be glad I got out.
Risk management isn’t just cutting your losses. It could also be a situation where you take a small gain to ensure a gain happens to your account rather than keep your trades exposed to a pending news announcement that no one is sure what it will do to the markets.
KO hasn’t done much since the trade was put on, resulting in theta decay affecting this trade more so than delta or gamma working in our favor.
Here’s your trading lesson summary:
STRATEGY: Managing your winners
- Never let a winner turn into a loser.
- Protect your profits.
- Pay attention to the markets.
The Fed may well tell the markets exactly what they want to hear, sending stocks higher and our bullish option trades into the stratosphere.
But no one knows exactly what the Fed is going to do. It’s essentially a gamble to wait and see.
I’m not willing to risk actual profits for the potential to do a little bit better.
America’s #1 Trader