Position Management

efore establishing any position it's important to establish a few guidelines for yourself:

• Are you trading with money you can afford to lose?
• Is the position you intend to put on sufficiently small that it won't have a major impact?
• What is your specific objective for this position? What is your exit strategy?
• What is your downside risk?

Are you trading with money you can afford to lose?

The importance of this cannot be overstressed. If you have already earmarked the money for another use, it is not advisable to invest it in a risky position--even for a short term trade. Every day the market extracts money from people who can't afford to lose it. Don't be one of them.

Is the position you intend to put on sufficiently small that it won't have a major impact on your portfolio?

This is a guideline novice traders routinely violate. Experienced traders caution people against putting on positions that will have devastating results if the market moves the wrong way. Some traders go so far as to say that positions should be so small that putting them on seems almost meaningless. Typically, the percentage of your portfolio associated with this would be 1/2% to 1%. Keep in mind though that this applies to traders more than long-term investors. This is not to say that investors wouldn't benefit from the same advice. They probably would. It's just that a disciplined approach is particularly beneficial to option traders who could easily lose their entire investment.

What is your specific objective for this position? What is your exit strategy?

These issues are inter-related so we will examine them together.

First, whenever you put on a position, it's important to set a price target along with a strategy for what happens when you get there. For example, if you are convinced a particular Internet stock is hugely overvalued (imagine that!) and due for a correction, you might decide to buy a long put either at-the-money or slightly out-of-the-money. If the market behaves as you predict and the price drops, you have to decide how far to let your profits run and at what point to take profits.

If the stock drops 50% and your put is now deep in-the-money, this might be a good time to take profits. On the other hand, if you think the stock is still overvalued, you could buy a slightly out of the money call and let the put ride. For example, if the stock dropped from $100 to $49 and you own the 95 put, you could lock in your profit by buying a 50 call. This way, if the stock goes back up, what you lose in the put will be made up by the call. If the stock continues to drop as you hope, the put will increase in value and the call will expire worthless. Whatever you decide, it's good to have your strategy thought out in advance. This helps to take the emotion out of it.

What is your downside risk?

With option spreads and other advanced strategies, your maximum loss may be more than your initial investment. Before entering into any trade, it's important to know your maximum profit, maximum loss, and break-even. Trading surprises are seldom pleasant.

Modifying and Managing a Position

Depending on market conditions, option investors may need to modify their positions either to lock in profits or protect themselves from adverse moves.

Protecting Your Profits

Taking the easiest example, let's imagine you bought a long call and watched with interest as the stock rallied. How can you protect what is now a paper profit? Considering the additional stock commissions involved in exercising the option, we'll disregard this as a strategy and focus on other alternatives.

The dilemma whenever a position makes money is when to take profits and when to let profits ride. By selling the call, you lock in profits, but you may miss additional upside. On the other hand, if you sit tight, the stock could pull back below the strike price. In this case, you would lose your additional investment as well as your paper profit. Fortunately, there are other alternatives.

Now, let's imagine you bought an AT&T August 35 call for 1.75 when the stock was trading at 33.38. Shortly afterwards, the stock rallied to 42 where your call was worth 8.5. Rather than sell the call, lock in the profit and walk away (which is a perfectly acceptable strategy), you might sell the 35 call and buy the September 45 call for 1.5. The profit you make on the Aug 35 call will more than cover your investment in the September 45 call. As long as the stock climbs, you can continue to lock in profits by rolling your options to higher strike prices and subsequent months.

The other possibility would be to transform the position into a bull spread by holding the August 35 call and selling the August 45 call. With AT&T at $42, the August 45 call will probably be trading around 1.35. By selling the 45 call, you effectively own a 10 point bull spread for .4 of a point (1.75 - 1.35). If the stock continues to rise, 10 points (less your .4 point investment) will be your maximum profit. Should the stock suddenly drop back below $35, the most you can lose would be .4 point or $40.

The important point to note is that the riskiest course of action is to do nothing because your initial investment remains at risk along with any paper profits you have generated.

Limiting Your Losses

Let's imagine you bought an AT&T August 35 call for 1.75 when the stock was trading at 33.38. Shortly afterwards, the stock dropped to $30 where your call was only worth $1. If you sell the call, you may limit your losses, but you'll also eliminate the opportunity to profit from a rebound in the stock. On the other hand, if you sit tight, the stock might never regain strength in which case you'll lose your initial investment. Here again, there are other alternatives.

Rather than sell the call, lock in the loss and walk away (which is a perfectly acceptable strategy), you might consider selling two August 35 calls at 1 and buying one Aug 30 call for 2.65. This way, you will create a bull spread using the 30 strike because you will be long one 30 call and short one 35 call. Thus, for an additional .65 investment, you now have increased the likelihood that the position will be profitable. Before, the stock would have had to go over 36.75 for you to make a profit. Now, the break even is 32.35.

The other possibility would be to transform the position into a calendar spread by holding the August 35 call and selling the July 35 call at .75. This course of action would make sense if you expected the price to remain depressed through July but expected a rally shortly afterwards. Ideally, the short July 35 call would expire worthless and the stock would rally as expected. If the stock rallies before July expiration, the price differential between the July and August 35 calls may be limited as will your profit potential. In contrast, if the stock fails to gain strength, your maximum loss using this strategy is significantly less than it was before you put on the calendar.

Here again, the riskiest course of action is to do nothing because the full value of your initial investment remains at risk.