Learning to trade options offers a number of unique advantages to the trader, but perhaps the single most attractive characteristic is the ability to control risk precisely and to do so with precision. Much of this advantage derives from the ability to control positions equivalent to stock with far less capital commitment.
However, a less frequently discussed aspect of risk control is the ability to moderate risk by the astute use of time stops as well as the more familiar price stops more generally known to traders. Because time stops take advantage of the time decay of extrinsic premium to help control risk, it is important to recognize that this time decay is not linear.
As a direct result, it is not obviously apparent the time course that the decay curve will follow. An option trader has to take into account that the option modeling software is essential to plan the trade and decide the appropriate date at which to place a time stop.
As a simple example, consider the case of a short position in AAPL established by buying in-the-money March 470 puts. A trader could establish a position consisting of 10 long contracts with a position delta of -595 for approximately $22,000 as I write this.
At the time of this writing, the stock is trading around $459; these puts are therefore $11 in-the-money. Let’s assume a trader analyzes the trade with an at-expiration P&(L) diagram and wants to exit the trade as a stop loss if AAPL is at or above $462 at expiration. The options expiration risk is $14,000 or more. However, if the trader takes the position that the expected/feared move will occur quickly—long before expiration—he could
implement a time stop as well.
Using a stop to close the position if the stock gets to $462 at a point in time around halfway to expiration would reduce the risk significantly. Because the option would still have some time value, the trader could sell the option for a loss prior to expiration, therefore retaining some time value and fetch a higher price. In this event, closing prior to expiration helps the trader lose less when the stop executes, especially if there is a fair amount of time until expiration and time decay hasn’t totally eroded away.
Options offer a variety of ways to control risk. Learn and use all risk control maneuvers available; life is a risky business.
Senior Options Instructor