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This is a level 3 question.
I have been paper trading bull put credit spreads, and I do not know what action to take when the underlying stock price closes within the spread. Do you have any suggestions before I start doing actual trades?
It is great that you are thinking about questions such as this before starting to actually trade. Congratulations! You have made a significant jump in the process of becoming a successful trader. We see many people who are so anxious to start trading that they forget to think through the whole process - when to get in, when to take profits, and when to get out if things don't go as planned. What we tend to see instead are people that panic when things go astray. Inevitably, they exit at the most inopportune time. In contrast, the best traders have sets of contingency plans prior to entering a trade as to when they will exit and what criteria they'll need to see to exit the position. This is because it is very tough to come up with an unbiased plan when you are caught in a middle of a bad position. The mental energy needed to successfully think through all the possibilities and to weigh them correctly is just too difficult if not dealt with beforehand. However, in your case, you seem to be ahead of the rest of the pack and if you continue to think like this, you will do well.
A credit spread involves the simultaneous purchase and sale of out-of-the-money puts (a bullish spread) or calls (a bearish spread) that expire at the same time but have different strike prices. For more information about credit spreads, check out our real-time recommendation service, Bernie Schaeffer's Wealthbuilder
To answer your question, the first thing to consider is your risk tolerance level. How much can you afford to lose? Second, what method did you use to suggest the trade in the first place? Finally, what resources do you have to track and follow the market? These all have an impact on your potential decisions.
Let's start with risk tolerance level. Risk tolerance and the ability to handle subsequent financial responsibility is an inherently personal matter that you must seriously address. From time to time, we see people who say that they want an aggressive, "swing-for-the-fences" trading style. But after a few months, we see them coming back saying what they really want instead is more consistency and less swings in their equity. They can't handle the emotional roller coaster.
The procedure is really dependent upon many things. If you are a discretionary trader, it is going to be tougher to analyze. You'll have to figure why and how you got into the trade in the first place and whether you would be willing to do this every time (or at least a majority of the time) these events occurred.
If you have a system, you can evaluate your system a little easier by testing the affects of the following ideas to see which is the most robust without curve fitting the answer to the best solution. You can test your system to see if a fixed or trailing stop-loss is best for your system. Fixed stop-losses don't change. From the minute you are confirmed as "in" the trade you enter, there is a corresponding stop-loss to exit the position based upon some set dollar amount, some percentage amount, or an important charting point. A trailing stop is one that follows the market upward if your position is looking for a higher market or vice versa if your system is looking for a down move. Trailing stops continue to advance as the market moves your way. If the market doesn't advance, the stop remains at the same level. The trailing stop can be based on a set dollar amount (say $500) away or a percentage amount (say two percent) away. As long as the market moves into new-high ground, the stops will be trailing by either the $500 or two-percent amount. Eventually, the market will stall and then reverse, thus setting off your trailing stops.
What you will have to do is analyze the risk taken with the position. Is earning 3/4 point while potentially losing 4-1/4 points worth it this time, particularly when you have 50 contracts on versus your normal 10-contract position?
Second, how committed are you to the trade? Maybe you should roll down or out of the position? Rolling down or rolling out basically extends your position. If your position is a loser, it will still be a loser afterward except you will have bought some extra time in which the situation might reverse and be able to recoup your investment. However, if the position has gone against you this far, it is best to cut the loser and look for a new situation. Start with a clean slate and no mental baggage.
Thirdly, does your trading dictate a style in which you need to know where the market is minute by minute. If it does, can you devote the needed resources to make it work? If you can't then, you will have to adapt to a longer time frame and possibly smaller amounts to reduce your risk exposure to acceptable limits.
Finally, don't bet everything on one trade. You have to realize that you need capital to play this game so that you can keep coming back to trade. Remember that you want to have a positive edge similar to a casino - over time, you will be able to play the game long enough to see the benefits of that positive edge. Therefore, one trade shouldn't make or break you, but it is the total accumulation of trades that will benefit you.
Good luck with your paper trades!
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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