STOP sign - limit losses

Selling options rule No. 2 – Limit losses

There is always the hope that we will make profit with our trades. However, there might be plenty of losses as well and there is the need to limit them.

If I sold a put option betting that a stock, which currently costs 100$, will not go below 90$, for sure, the aim is that the price of the stock will in the best scenario even increase. However, I cannot know this. Therefore, I need to be prepared what I should do when things go wrong. Then, we have to act. There is no place for panic.

The first thing is to have a very easily identifiable point when to “abandon the ship before it starts sinking”. This is particularly important, when selling options because options can multiply in price and that can lead to substantial losses. To illustrate this, if you buy a stock for $100, the maximum you can lose is exactly those $100.  If you sell an option for $100, losses can be theoretically unlimited. A price of an option which initially cost $1 (that would be $100 as one option relates to 100 stocks), can jump to $2, $3 or even more dollars. Therefore, one of the most important rules is to know when to cut losses and go out from a trade.

It is time to act

This rule has to be followed in every time, whatever happens. The automatic reaction, fueled by emotions, is to wait until the price jumps back in our favor, but you might wait on something that will happen too late. As Keynes said: “The market can stay irrational a lot longer than you can stay solvent!”. After your mental stop is reached, you have to go out of the trade. Have your mental stop defined. For one type of options, my mental stop is when the loss reaches 100% of the initial sum. Once this happens, I learned not to hesitate. As soon as I see it, I end the position immediately.

When things go wrong, it is the most important time when you have to stick to your rules.

Check out the other rules important for your trading.

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