When it comes to trading, opening a position is easy.
Whether you’re buying something out of FOMO or out of thoroughly reasoned analysis, most would agree there’s really nothing easier than clicking the buy button.
Selling, on the other hand, is about as hard as it gets.
Choosing when to sell is always difficult. In fact, it’s so difficult, many traders use rules of thumb.
They may cut losses when a position falls 10%. Maybe they take gains when the stock shows a 30% gain.
I say “maybe,” because we often find ways to convince ourselves to make exceptions and ignore these rules.
Other traders pretend selling doesn’t matter. They quote Warren Buffett and say their favorite holding period is forever.
Both strategies present problems to options traders…
In options, a 10% decline is normal and needs to be tolerated. Short-term volatility comes with the territory. This, of course, goes right against the idea of deciding to sell based on rules.
Furthermore, stop-loss orders should never be entered on options trades. They will almost certainly be triggered by market makers, and the loss will be locked in.
On the other hand, sticking to profit targets can prevent large winners. It’s obvious that taking a 30% gain every time means missing more than a few triple-digit gains. You can’t keep your profit targets at triple digits, either, because you might pass up a 90% gain that the market quickly takes back.
And just refusing to sell isn’t possible with options. Expiration dates force us to act. If we don’t, we will either have 100% losses or exercise the contract on every position.
Either way, this strategy will quickly consume all available trading capital.
Other traders believe they have a sophisticated selling strategy. They follow signals. For example, if you use a moving average, you sell whenever the price moves below the MA. Other indicators have similarly well-defined rules.
Here, the result will be a large number of whipsaw trades. A whipsaw trade occurs when the price moves above or below the MA repeatedly in a short period of time. Whipsaws are inevitable with technical trading strategies.
And they can be expensive when trading costs are considered. Remember, trading costs include spreads and taxes, in addition to commissions. Even with commission-free trading that many brokers tout today, trading can be expensive.
My Favorite Options Exit Strategy
For my ETF strategy, which I’ve introduced over the last month, I use a different selling strategy.
For a quick refresher, we buy an ETF when it has the highest relative strength. Most of the time, we will have 10 positions in the portfolio.
It seems logical to sell when an ETF falls out of the top 10. We won’t be doing that.
Instead, I use a cast-off selling strategy. We will cast the ETF off of our portfolio when it is no longer in the top 25% of the rankings.
This simple approach reduces the risk of whipsaw trades. It also allows us to hang on to winners as long as possible.
ETFs or stocks with high relative strength are usually the most volatile positions. They often pull back for a time and then resume their rally.
If we sell too early, we miss the next leg up. Using a cast-off rank of 25% gives the ETFs a chance to hold on to these big winners.
That cast-off rank also reduces the risk of holding on too long. When the trend does reverse, the relative strength rank will fall quickly. We have a strict rule for when to sell so we avoid hanging on too long, but one that keeps us in the best trades for longer, and only gets us out when the conditions for buying in the first place are no longer in play.
What’s great about this is it doesn’t necessarily mean the ETF in question has gone down significantly — it just means that there are better places to put our money.
I’ve studied many exit strategies over the past 30 years. This is the one I like the best for this strategy.
If you aren’t up to date on the latest holding of this strategy, you’ll want to catch up on my latest recommendations right here.
Michael Carr, CMT, CFTe
Editor, One Trade
Chart of the Day:
Small Caps’ Day Has Finally Come
After an absolutely excruciating year of price action for small-cap stock investors, the Russell 2000 (here represented by its ETF, IWM) has finally broken out.
Veteran readers might remember this chart from a few months ago. Your publisher Chris Cimorelli shared his very simple trading strategy with me: buy IWM at the bottom yellow line, sell at the top yellow line.
Well, he’ll have to find a new strategy. To borrow a term from crypto investors, small caps are in “price discovery” now.
I bring this chart to you today because it’s one of the healthiest breakouts I’ve seen in quite some time. Not only did the index break out on strong volume, it did so while making new highs on the RSI, and after a serious period of coiling on both the RSI and the MACD.
We’re backing off a bit from those highs now, but I’m hardly worried about that. In fact, small caps look set to outperform through the end of the year.
Managing Editor, True Options Masters