Click on the chart to enlarge it.
We're anticipating, not predicting; we still demand that price action trigger us into the trade. We're anticipating an immediate and significant decline in Amazon, so now we need to choose carefully which put option is appropriate.
Option selection is a science unto itself, but ideally we should be looking for an option with less than 30 days to expiration, whose strike price is at or in the money, and which has not already unduly appreciated in anticipation of the move in the underlying.
We expect to get the biggest bang for the buck from an “at-the-money” option. With prices trading at roughly $47 to $48, it just so happens that there is an August 47.50 put. It's got about 30 days to expiration, it's at the money, and as we'll see, it hasn't run away from us yet.
Speaking of which: Of the qualities necessary in a good option purchase, none is more important in my opinion than that the option moved against the anticipated trade on the day prior to entry. Tom DeMark taught me this simple rule and it's worth its weight in gold. It squishes some of the premium out of the option and prevents us from chasing it and paying too much.
In markets other than options, where ample liquidity is available, we employ an entry trigger and initial stop strategy that almost always limits losses to the range of a single bar plus a couple of ticks.
However, options typically have a more expanded bid-ask spread, which requires us to place the entry trigger and initial stop outside the bounds of a single bar. This helps to avoid being falsely tripped in or knocked out due to the unavoidable effects of the bid-ask spread.
This additional breathing room will have a minimal effect on the profit potential of the trade, nor will it add much to the risk profile, but it helps to filter out false signals in these thin markets.
The initial mental stop should already be determined (based on rules explained in the Ocean workshop) and ready to be executed should price action trip us into the trade and we're hit with a negative surprise.
But opening gaps in options are common. So although we have a precise dollar contingency for exiting the trade we may not be able to execute it before the option has gone past our point. Since options are often illiquid and sport large spreads (in percentage terms), air pockets occur frequently and by the time we exit a trade it can be well beyond where we intended.
Thus only a tiny percentage of our total account should be committed to an option campaign. The potential rewards are high enough so that a small equity allocation can have a significant impact on our overall results.
Based on experience, I offer this suggestion for taking profits in an option swing trade: If we're fortunate enough to double our money (100% return) we should exit and pocket the gift. However if this return occurs intra-day I'm inclined to monitor the position closely, hoping for a little more juice. If any signs of weakness appear I'll exit immediately; otherwise I'll exit near the close.
It requires discipline to bail out of a position moving in our favor, but a 100% return is already substantial and some very bad habits can be learned when expectations in an option swing trade go much beyond this goal.
(This is the end of Part 6. Go to Part 7.)
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