   3: Taking the Loss One of the more important skills you have to master as an options investor is recognizing when to take the loss. Sometimes, the reason why you entered a trade - positive short-term outlook for the company, or a hot new product - has gone away. The company might need more time to reach your stock price target, or analysts downgrade the stock, or that hot new product doesn't meet sales expectations. Whatever the reason, if your reason for entering the trade has gone, then after proper consideration you should consider whether the trade is worth repairing or if you should just "get the heck out". Let's say our friend Doug thinks Walmart has some great potential. The stock is currently at $52, and he thinks that the retailer can hit $60 by the end of the year. Doug doesn't want to spend $52,000 for 10,000 shares, so he purchases ten (10) JAN'01 $50 CALL options for $6,500 instead. So he now sits back and waits for the stock to start to make its move. Well, two months later, several analysts come out and downgrade the stock. The company itself is warning of slower growth and decreased revenue estimates going forward. Walmart has gone down to $45 a share on this bad news. Doug does his homework, and figures that $60 a share is going to take a lot longer than he expected. With a few months left until expiry he can do one of three things: Scenario A: He can simply hold the option until expiry. The "do nothing" approach is easiest, as it requires no action on Doug's part. The stock might make it back to $50, and he can get some or most of his money back. Scenario B: He can try to repair the trade. He can sell the JAN'01 CALLS and buy APR'01 CALLS instead. This will cost him a few more bucks (on commissions and in buying a little more time value) but it will give Walmart a few more months to recover. Scenario C: He can recognize that the reasons he entered the trade have disappeared, and just sell his JAN'01 CALL options. Yes, he will lose money on the trade, but remember that he will lose less dollars on an options trade than if he had bought the stock outright. (Options generally only gain or lose 50 cents for every dollar change in the price of the underlying stock.) What does he do? He realizes that the stock will have to get to $56.50 for him to breakeven. He doesn't think that can happen by JAN'01. It doesn't make much sense for him to hold his options for so long to lose all or most of his money, so he investigates his repair strategies. He can sell his options and buy some with a lower strike price. Or he can buy some more time. Or both. He can sell some CALL options against the ones he owns to create a spread. None of these options seem viable to him. So in the end he just sells his options, recovers about half of his money, and goes on to his next trade. You can't win them all. ©2001 xguru, Inc. A Cardinal Factor Company. All rights reserved. |
