Today I’d want to talk about 5 easy steps you can use to manage defined risk trades.
The importance of having a set of mechanics that you follow with each trade cannot be overstated. Markets are dynamic. They move around constantly. Even the most conservative stocks can exhibit unpredictable moves. And knowing what to do when changes occur will give you a greater sense of confidence in your trading decisions.
So let’s take a look a 5 steps you can take as your trade evolves, or if the market throws you a curve ball.
Defined Risk trades can be an excellent place to start as you begin your journey to learning to trade options. Defined risk trades have a clear max profit and max loss potential and are a proven approach to generate consistent returns during various market cycles.
This scenario will look familiar.
You made a good decision about a stock you want to trade. You applied the rules for initiating a trade (High IVR, directional bias, price, liquidity, Risk/reward). You chose a strategy that made sense. You knew your max profit and your max loss, You placed the trade, and the order was filled.
Then WHAM!! somebody drops a rocket on Iran and the S&P 500 index drops 20 points in about 5 minutes.
What to do now
The first thing to do in not panic. Markets move. A catastrophic event does not happen everyday. I am mentioning this because you need to be prepared mentally in case it does. You decided your max loss before you placed the trade and you set your strikes at an apporopriate distance away from the current price. You cannot lose more than your max loss in a defined risk trade.
And remember. Options are time contracts.This is why using contracts with expiration dates 45 to 60 days into the future gives you time for the probabilities to play out in your favor.
Here are some standard rules to follow for any Defined Risk Trade
- If the position has more than 21 days to expiration (DTE), do nothing until 21 DTE. You are still on the dance floor and no need yet to change partners.
- If the position has 21 or fewer days to expiration (DTE), and the IVR is high, close and reestablish the position in the next expiration cycle (roll). High IVR means opportunity. By rolling out to the next expiration you are giving yourself more opportunity to succeed.
- If less than 21 DTE and IVR is low (less than 30), and if the position is at a loss, hold until a scratch or expiration. Your risk was defined at entry. You can never lose more than that amount.Strikes being touched during the course of a tradeare a common occurance. Let the probabilities play out.
- If the position is profitable or scratch, close the position.
- If at some point between entry and 21 days,you have a profit of 50% of the credit received, close the position and redeploy the capital in another trade.
That’s it. That’s really all you need to do with defined risk trades.
Having a set of rules to follow as your trades evolve will give you a greater sense of confidence in your decision making skills. Not every trade will work out in your favor. But if you are consistent in your approach and let the probabilities work out, you can have a good deal of success in your trading activities..