Stop Me In Time
Stop Me In Time
Options offer a number of unique advantages to the trader, but perhaps the single most attractive characteristic is the ability to control risk precisely and to do so with surgical precision. Much of this advantage derives from the ability to control positions equivalent to stock with far less capital commitment.
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However, a less frequently discussed aspect of risk control is the ability to mitigate risk by the judicious use of time stops as well as the more familiar price stops more generally known to traders. Because time stops take advantage of the time decay of extrinsic premium to help control risk, it is important to recognize that this time decay is not linear.
As a direct result, it is not intuitively apparent the time course that the decay curve will follow. A corollary of this is that option modeling software is essential to plan the trade and decide the appropriate date at which to place a time stop.
As a simple example, consider the case of a short position in CVX established by buying in-the-money June 75 puts. A trader could establish a position consisting of 10 long contracts with a position delta of -641 for approximately $3100 as I write this.
At the time of this writing, the stock is trading around $72.87; these puts are therefore $2.13 in-the-money. Letís assume a trader analyzes the trade with an at-expiration P&(L) diagram and wants to exit the trade as a stop loss if CVX is at or above $74.50 at expiration. The options expiration risk is $2615 or more. However, if the trader takes the position that the expected/feared move will occur quicklyólong before expirationóhe could implement a time stop as well.
Using a stop to close the position if the stock gets to $74.50 at a point in time around halfway to expiration would reduce the risk significantly. Because the option would still have some time value, the trader could sell the option for a loss prior to expiration, therefore retaining some time value and fetch a higher price. In this event, closing prior to expiration helps the trader lose less when the stop executes, especially if there is a fair amount of time until expiration and time decay hasnít wreaked too much havoc.
Options offer a variety of ways to control risk. Learn and use all risk control maneuvers available; life is a risky business.
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