Recently, a subscriber to the Option Trader service wrote to ask why I bought LEAPS (that expire a year to three years out) when I only planned to be in a trade from 1 to 3 months. That is definitely a great question that raises what I consider to be some very important issues about all trading, whether stock or options.

The first answer with regard to my own trading is that I do not employ an exit strategy based upon how long I plan to be in a trade. In other words, when I enter a position, the length of time is not going to be the reason for my exit (unless, of course, it is an option that expires). I try to remain in a position depending upon the price behavior of the stock. Why, for example, would I want to exit a bullish position when the stock is continuing to move up? That action would serve to cut my profits and that is something I want to avoid. Similarly, if a position turns against me, I want to get out. I want to cut my losses and let my profits run.

Unfortunately, and all too often, investors have no exit strategy. Witness so many in the most recent bear market who have seen their portfolios drop 40% or 50% or more. Many times they remain in positions because they are "investing for the long term." Sadly, that has not worked for those holding stock in companies like Enron, Lehman Brothers, Bear Stearns, or Washington Mutual. An exit strategy that is only defined by time can result in some very serious losses.

Instead of defining my exit strategy solely by time, I try to use a specific discipline that I pre-determine before I enter the trade. I might use a break through a moving average or a break through a trend or the crossover of two moving averages. The choice can vary from play to play, but it is based on some discipline other than the passage of time.

Specifically relating to the subscribers question, when I buy call options, I buy a lot of time. Generally, if I remain in the position it is either because the stock price is continuing to move up or because I want to use the position as an underlying against which I can bring in income by selling other options. Additionally, buying long term options or LEAPS (technically Long Term Equity Anticipation Securities) the time decay portion of the premium initially does not run against me as quickly and I often can find a better delta than I would at the same strike price with a nearer term expiration.

I would add one thought and that is some successful traders do use a time stop to exit positions quickly if the play does not begin to run in their favor relatively quickly. For example, even if I were using a price support as an exit, I may have decided in advance to exit my position if the stock doesn't move my way within 2 or 3 days.

Bottom line, for me, is to let the stock price movement make the decision for me when to get out rather than to use a purely time-based exit.

Good Trading!
Bill Kraft

February 21, 2009

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