Defending losing options trades
🤔 This is another post in a set of posts on options trading. If you are new to options trading, you may want to start with some of my earlier posts.
You did your research. You waited for a good time to sell a put option. You received a decent premium for your option trade. Now your trade has turned into a loss. What can you do now?
There are good choices for these situations, but there’s something important to remember. If you made the trade with strong conviction, you know your maximum loss, and you like the stock, then sticking with your original plan might be the best option.
This post will cover some common options scenarios and what you can do to work through a losing trade.
Losses in the first hour after making the trade
It’s very common to sell an option, either puts or calls, and see the trade show up as a loss immediately. This is unsettling as you first get started with trading.
Often times, this happens when you sell near the bid side of the bid/ask spread. Remember that these spreads have a few properties:
- Bid: What the buyers are offering to pay to buy an option.
- Ask: Price at which sellers are willing to sell their option.
- Mark: Halfway in between the bid and ask price.
- Last: The price of the last trade that was made.
Almost all brokerage software shows the current price for a stock or option as the mark price. If the bid/ask spread is $1.00 and $1.10, then the mark is $1.05.
If you sell an option at the bid price of $1.00, your trading software knows the mark price is $1.05. You will see a $0.05 loss on your trade. That doesn’t mean that you lost money, but it does mean that you could have made an extra $5 in premium on the trade. To avoid this, make your next trade at the mark price or higher. Everything has a downside, and the downside of making a trade above the bid price is that your order fill may be delayed or may not occur at all.
Keep in mind that when you sell options, you make more money on volatile stocks. Volatile stocks have a high probability of larger price changes. After you sell your option, the underlying stock can move downwards a little, and this makes your sold put more valuable. Stick with the conviction you had when you originally made the trade and give it a little more time.
The underlying stock price moved down closer to the put strike price
Let’s say you’ve sold a $100 put on your favorite stock, and a few days later, the stock moves down to around $102. You will see a loss in your trading software. The put option gained value as the stock moved closer to the strike price.
At this point, you still have your premium in your pocket and the stock is still over the strike price. You are in a good position to exit the trade profitable and the best option here is to wait.
On the flip side, if you sell a covered call at $110 and the stock creeps up to $108, your best option could be to wait.
The stock price moved just under the put strike price
This was a spooky situation when I first started trading. Let’s say you sold a $100 put for $2.50 premium and the stock moved down to $98. Your put is now “in the money” and it’s a lot more valuable than it was when you first sold it. You will see a loss in your trading software.
Your breakeven on this trade is $97.50 since the strike is $100 and you received $2.50 in premium. If the stock is at $98, then you are still sitting on a $50 profit.
When my trades reach this point, I will usually hold and wait. Best case, the stock will go back over the strike price and I can buy back my put for a profit.
If it expires in the money, but I am above the breakeven, I get a little less profit (still a profit!) and I hold 100 shares. I can then sell covered calls to collect more premium.
The stock price moved well under the strike price
In our previous example, we sold a $100 put for $2.50 in premium. What if the stock price moves down to $90?
At this point, you have a loss on paper of $750 since your breakeven is $97.50. Your put is “in the money” and you will likely be assigned 100 shares. Buying back the put doesn’t make much sense here unless you have a very strong conviction that the stock is going to go down a significant amount.
The goal is to reduce your cost basis. Your cost basis is how much you spent to get the shares you have. In this example, your cost basis is $97.50 when the stock price falls to $90.
Buy shares. You can reduce the cost basis by buying shares at $90. Do your research and ensure that the stock has some clear indicators that it is bottoming out. Use indicators like the 14 day RSI under 50%, stock price touching 50 or 200 day moving averages, or positive news about the company. Be careful here because you don’t want to throw good money after bad.
If you know you’ll have 100 shares at a cost basis of $97.50, buy 100 more at $90. That lowers your cost basis down to $93.75. If the stock price begins moving up, you’ll collect those gains and be able to sell two covered calls instead of just one.
Sell more puts. Selling puts allows you to collect more premium or potentially get assigned at a lower price. These can help you reduce your cost basis further. As said before, be sure to do your research to ensure the stock is bottoming out. Taking a loss on a second put will be frustrating.
If you sell an $85 put for $3.00, the stock stays at $90, and you get assigned on your first put at a cost basis of $97.50, your cost basis drops to $94.50 with the collected premium from the put.
Closing deep thought: volatile stocks are volatile
The more volatile the stock, the higher the premium when you sell options. That’s because the options buyer is paying a premium to transfer some risk to you, the seller. There’s always a risk of getting assigned, and sometimes those assignments are done at a loss.
When your option trade turns red, keep in mind that the volatility that sent the stock price down could easily send the stock price back up. You entered the trade with a strong conviction and often the best action to take is no action at all.
Stay focused on your cost basis and think about what you can do to lower it. Buy shares when the stock falls and begins to bottom out or sell more options to collect premium.
Disclaimer: Keep in mind that I am not an investment professional and you should make your own decisions around stock research and trades. Investing comes with plenty of risk and I’m the last person who should be giving anyone investment advice. 😜
Photo credit: Yuriy Bogdanov on Unsplash