Ken Trester

Use Trailing Stops to Protect Option Profits

by Ken Trester   08/25/08

Whether you're just considering trading options for the first time or you've been doing this for decades like I have, you're not in this game just to make small wins. No doubt you're looking for how to double, triple or even quadruple your money.

And not only is it possible, but once you learn how to stack the odds in your favor, those big wins can become a reality over and over again.

Winning big starts by finding low-priced options and placing your bets on the table before a big pop (or drop) takes place.

But the real magic happens with a well-managed trade -- when we're situated in a call or put option position and we see the underlying stock make the big move that we anticipated.

The fun is far from over at that point. In fact, that's when things start getting good!

Big gains or losses in stocks tend to occur quickly, not gradually. So, it behooves you to check in on your options portfolio with more frequency than your long stocks. You want to be on your toes when your trade gets up and starts running, because your job is to squeeze out as many gains as possible from a profitable trade, and that sometimes requires some stealthy footwork.

When a trade starts to go in my favor, I like to take profits on a portion of the position right away. For example, if an option trade doubles in value, you should cash in on half of your contracts. If you have 10 contracts on the table and your $1.50 option hits $3, then take five contracts off the table. That way, you have preserved your original investment capital and the remainder that you're leaving in play represents pure profit.

While many traders set sell stops below their options, I prefer to set one on the underlying stock. What I recommend using is called a "trailing stop," which adjusts as the stock moves in your desired direction, whether you've bought calls in anticipation of the stock going up or whether you're using puts to profit as the stock goes down.

So, if you own a call option and the underlying stock rises, adjust your trailing stop higher so that it is not more than 3% to 5% below the market price of the stock. However, if the stock that you are bullish on falls, do not adjust your trailing stop. This way, you are protecting your profits and are not tempted to "hang in there" to see if you can make even more money.

When the trailing stop is triggered, it's your very-clear signal to run, not walk, to the exits!

I like to use a stock's closing price to determine whether or not the trailing stop was triggered. Especially when the markets or an individual stock or sector is experiencing wide swings during the day, how the stock closes for the day is more important than how it might have traded throughout the session.

If the stock price closes for the day below this level, cash out of your option position. But if shares keep going up, keep on bumping up the stop and enjoy the ride!

The opposite is true for a put option; adjust the stop lower if the stock falls, and leave it where it is if the stock rises. And if it keeps rising, maybe you should think about buying a call option next time around!

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If you enjoyed this article, check out Ken Trester's "Take Options Losses in Stride" and "Selling Options Can Generate Instant Profits."