When Options Become Too Risky: How to Know When to Walk Away from a Trade

You start out your trading session with some promising prospects, but then half way through the day, the signs of increased risk begin showing up with the options you’ve chosen. Something that happens to traders of all skill levels is the emotional pull to stay in a trade too long, hoping things will turn around. In many cases, these trades go south fast, and the trader feels they should have pulled out when all the warning signs and red flags were there.

Sometimes, the best decision in options trading is knowing when to leave a trade. This article will help you identify key warning signs and provide actionable steps to avoid unnecessary risks. What are the red flags to watch for in options trading, and how can you protect your portfolio by stepping away at the right moment? Keep reading to find out!

The Emotional Trap—Why It’s Hard to Walk Away

Traders find stepping away from losing trades challenging for several psychological reasons. We understand that this sounds like we’re thinking too deeply into the matter, but there are some deep-seated reasons traders find it hard to let go of trades they’ve invested time and money into: fear of missing out (FOMO), greed, and loss aversion.

Key Points

Let’s examine the specific reasons traders find it challenging to depart from trade decisions for which they’ve dedicated resources. In many cases, it’s the sunk cost of the deal that makes it difficult to back out, but there are also a number of psychological reasons.

• Emotions Can Cloud Your Judgment: In high-stakes options trading, your emotions can get in the way of making sound financial decisions for the health of your online portfolio. Emotions like fear or greed can cause traders to make decisions that aren’t the best because they’re rooted in illogical reasoning. For instance, a trader might feel they will miss out on potential profit by cutting loose a losing option when the best decision is likely to get rid of it and reallocate the capital elsewhere. Emotions lead traders to make decisions that hurt their portfolios when the best course of action is to follow the logic and reasoning of a trading plan.
• Have a Clear Exit Strategy In Place: Before entering any trade, traders and investors need to understand the conditions under which they must exit a trade decision. Before exiting an option, a trader should be willing to lose or gain a certain amount of money. Once these limits have been hit in either direction, the trader will know when the time is appropriate to cut the trade loose.

Top Emotional Mistakes That Can Cost You in Options Trading

We’ll highlight the top emotions that can hinder an online trader’s success. It’s best to approach trading with a plan that keeps you in a logical and rational frame of mind. It’s these anchors, not emotions, that separate successful traders from struggling or failed ones.

Overconfidence

After a trader has made a profit or experienced a string of successes, it can be tempting to think the success will last indefinitely, and some traders will begin straying away from the fundamental concepts of their trading plan. For instance, traders will up the amount of capital allocated to each option or position to maximize their profits even more. Overconfidence can cause some traders or investors to spread themselves thin with new investments, leading to the major mistake of “overtrading,” which is doing more business than their capital can realistically support.

Holding Out

Some traders will fall into the false assumption that the market is bound to turn around and that their losing position will begin doing well again once the rebound occurs. This differs from the “fear of missing out” that we’ll discuss in the next point. Unless you have some excellent information that guarantees the market will turn in your favor, it’s best to let go of losing positions when the warning signs are there. It’s best not to hold out for anything but instead replace lackluster investments with profitable ones.

Fear of Missing Out (FOMO)

Some traders fear they’ll miss out on a great opportunity if they cut a losing option or position from their portfolio. A losing position is only eating up capital you could use from profitable positions, and there’s no guarantee that things will turn around. Viewing trading through the lens of fearing missed opportunities is a losing game, and it’s best to allocate your money to healthy positions that lead to steady growth. Cut loose the options weighing down your portfolio’s value and replace them with profitable ones.

Laziness

A poor work ethic, a lack of discipline, and an attitude of wanting success quickly without putting in the proper work necessary can lead to a host of trading mistakes, including trading without a plan (no stop loss mechanisms, no profit targets, etc.), trading based on anecdotal evidence, neglecting risk factors, not trading based on value, or not calculating expected returns ahead of time. Laziness might be the most dangerous emotion that can screw things up for online traders.

Key Warning Signs—When an Options Trade Becomes Too Risky

What signs and indicators indicate that it’s time to let an options trade go? This section of the guide will identify and address the specific red flags that show it’s time to walk away from a trade. Though it might be tempting to hold onto a trade because it might turn around or because you’ve dedicated a lot of time to it, it’s best to stick with your trading plan and get rid of positions when you see these red flags pop up during your trading session.

Key Points

• Volatility Spikes: Sudden, unpredictable market movements (volatility spikes) can increase risk dramatically, mainly if you sell options from high volatility and are short on uncovered options. If the market moves sharply in one direction or the other, selling options can leave you exposed and prone to significant losses. Because of these market spikes, traders follow the age-old rule: “buy low and sell high.” It’s best to sell options when the market is stable and pricing is ideal. If you see the market turning and your options losing value, it’s best to eliminate them as soon as possible.
• Significant Price Swings: Strong price swings in either direction ease into trading rangers where recent price changes are consolidated. This leads to a favorable, low-volatility environment where profit-taking is best encouraged. Therefore, large swings in stock price should signal caution to investors and traders to get out while the going is good. With those options, they can lock in a good profit or take a minimal loss before things bottom out.
• Deteriorating Fundamentals: When a company’s underlying fundamentals shift negatively, it could be time to exit the trade. These downgrades in stocks could result from a change in management, new regulations, a significant announcement by the company, or unexpected financial numbers in the latest statement. When a company’s fundamentals deteriorate, dropping these options or positions is best, even if they incur a loss. The sooner you can get out of those investments, the better.
• Time Decay (Theta Decay): The passage of time can erode the value of an options contract, which is incredibly close to expiration. It’s less advantageous to walk away from trade if it’s getting closer to the expiration date, so the general rule of thumb is selling earlier rather than later, as it gives the buyer more time to benefit from the option or position. Closing out options before they expire helps investors protect their money and avoid major losses down the road.
• Unexpected News or Events: Mergers, regulatory changes, or geopolitical events could impact the trade for good or bad. It’s important not to have a knee-jerk reaction to the news and sell off because you fear your momentum is over. Once you get an idea of what’s going on as more news continues to come in, you can make better-informed decisions. It might be a good time to buy options that other investors are panic-selling. However, if the trend shows that your trades are deteriorating in value, it’s best to sell off as soon as possible. Traders are usually willing to buy them up, with investors looking to dump them quickly at a reasonable price.

Financial Limits—Setting Personal Risk Tolerance

Every trader should have a personal risk tolerance, which is how comfortable you are with risk. The only way to discover your risk tolerance is by knowing your trading goals so you don’t make costly mistakes. This next section will highlight how to set your risk tolerance and stick with it as you would with your overall trading plan.

Key Points

• Determining Your Maximum Acceptable Loss Per Trade: This will look different for each trader. However, the key idea here is to set up a loss limit that doesn’t make up a considerable portion of your available capital. A good rule of thumb is to embrace the “1-2% unit” for each investment—you only allocate as much as 2% of your total bankroll to each option trade. You only stand to lose 2% of your capital in each investment, a relatively average acceptable loss per trade. Again, this might be different for investors with a higher risk tolerance. They might up this amount to 3% or 4%. It all depends on how savvy you are in trading and how much capital you have to work with.
• How to Balance Potential Risk vs. Potential Reward: This strategy begins with understanding the risk-reward ratio, which you calculate by dividing your potential profit by your potential loss. A good ratio to shoot for is 1:2 (for every dollar you risk, you must gain at least two dollars). A healthy risk-reward ratio is rooted in setting straightforward entry and exit points, choosing the right strategies based on the current market conditions, and effectively using stop-loss orders to control where your capital goes.
• Use “Stop-Loss” Limits to Automatically Exit Risky Trades: There is always the chance the market will move against you, but how much are you willing to lose before cutting losing trades loose? This is where it’s helpful to set up stop-loss limits where options are automatically sold once they reach these predetermined limits. You have to decide how much you’re willing to let the trade lose before having it automatically booted from your portfolio.

Questions to Ask Yourself Before Entering a Trade

Another way to examine effective options trades is to ask yourself important questions about each trade. Asking yourself these same questions with every trade you’re considering can remind you of your goals, trading parameters, and your tolerance for risk in each scenario.

• How much can I afford to lose?
• Is the potential upside worth the risk?
• How much money will I dedicate to this trade?
• What’s my trading plan for this option?
• What are my goals for this trade?
• When will I set the expiration date for?
• What’s the market like, and what strategy will I use for this trade that works in those conditions?
• What’s the risk-reward ratio?
• How much will I profit from this trade before letting it go?

Technical Analysis—How to Spot a Weakening Trend

With online options trading, technical indicators are your best friend. They can help you spot a weakening trend, which shows that trades are becoming too risky. Readings and indicators include the Stochastic Oscillator, Moving Average Convergence Divergence (MACD), and Relative Strength Index (RSI), which are helpful for investors who want to know if their securities are significantly oversold or overbought. These factors can indicate possible trend reversals in the future or increased risk that can work against the investor.

Key Points

What technical analysis tools are available to traders and investors who are trying to spot weakening trends in their trades? We’ll highlight three important instruments for spotting these patterns, which indicate that trade has become too risky and needs to be let go.

• Moving Averages: These are constantly updated averages that can aid traders who want to smooth out price data to identify trends in stock prices. In particular, a price crossing below its moving average can be a sell signal because it indicates that bearish conditions are on the way. The stock has most likely lost its bullish momentum and could be entering a downward trend.
• Relative Strength Index (RSI): To see if an option is overbought or oversold, check the RSI chart. If it’s above 70, the option is likely overbought, while a reading of 30 or below indicates that it’s oversold. High RSI readings show potential selling opportunities, while low readings indicate buying opportunities. In relation to using the RSI indicators to identify if an investment is becoming too risky, traders will want to look at selling a stock if it’s drawing nearer to the 70 mark.
• Support and Resistance Levels: When a stock fails to break through key support/resistance levels, it could be a sign to exit. The idea is that prices falling below a support level become resistance, and prices falling below a resistance level become support. As supply and demand shift, the pattern or trend will reverse based on each breached level. Seeing a stock’s support level breached usually indicates that you should consider selling it off.

Sticking to Your Plan—Developing and Following an Exit Strategy

Another of a trader’s best friends is a disciplined approach to options trading, especially when it comes to sticking with a solid exit strategy for losing trades. Exit strategies are a vital component of getting out of traders that aren’t benefiting your portfolio, so it’s best to have a sound plan in place and apply it consistently to every trade.

Key Points

• How to Create a Clear Exit Strategy: Exiting a trade doesn’t always mean taking in loss. In many cases, you’re leaving a trade because you’ve made the money you have hoped for, and you’re moving on to other investments with that profit. Before every trade, you must develop an exit strategy which involves setting up profit targets and stop-loss levels. The profit target is the amount of money you can make on the trade before selling it, and stop-loss levels indicate the amount of money you’re okay with losing before selling.
• Trailing Stops: The role of these settings is to capture profits while limiting risk in a trade. It’s a conditional order that helps investors limit losses and lock in profits automatically. However, it’s different from a stop-loss order because the stop price can be adjusted as the market moves. Trailing stops move with favorable price movements but also close out traders where the price moves against the investor. The benefits include hedging risks, increasing the chances of making a profit and cutting back significantly on losses. However, premature exits are a common occurrence with the trailing stop orders.
• Knowing When to Accept Smaller Profits: It’s best to take gains in the 20-25% range because you’ll have the best trading experience when you’re selling the stock high and buying low. Waiting for the “big win” can quickly turn a modest profit into a loss, so it’s best to take the profit while you can and get out of the trade quickly so it’s still appealing to the buyer.

Brief Case Study

Let’s look at a real-world example of a successful exit strategy in options trading to give you a good understanding of how this would work using a certain amount of money and real-world market conditions.

For example, let’s say you have 40 puts you paid $6 for. You could close the order at 100% profit by placing a limit order at $12. In this scenario, commission costs aren’t a factor. The other option is closing them with a 50% loss by selling them with a stop of $3. Something important to remember is that this stop order doesn’t guarantee you’ll get the trigger price!

Avoiding Revenge Trading—What to Do After Walking Away

Revenge trading is similar to chasing losses in gambling. Traders will make emotional trading decisions to recover from a significant loss, hoping to recoup their money in the process. Unless you have a ton of capital at your disposal and have all the math worked out to recover the money and still make a profit, revenge trading isn’t advisable. It can lead to further losses that can cripple your portfolio and your trading outlook.

Key Points

Walking away from a risky trade can be emotionally taxing. Factors involved keep some investors emotionally attached to trades due to their dedicated time and money. Here’s how to avoid revenge trading:

• Recognizing the Signs: Revenge trading is easy to spot in yourself. Revenge trading and emotional decision-making only lead to worse choices and further losses, so know the signs and end emotional trading before doing something you’ll later regret.
• • Revenge Trading Signs
  • • You’re trading with unrealistic expectations or firm goals.
    • You aren’t reviewing your traders or learning from what you did.
    • You’re trading without a reason—you dive into trades without a solid plan in mind on what you’re hoping to achieve.
    • You’re trading based on extreme emotions like frustration, anger, or overconfidence.
    • You’re trading without setting up parameters for take-profit or stop-loss.
• The Importance of Taking a Step Back: Taking a step away from your trading session and going on a break is beneficial, especially for traders who have experienced an unsuccessful trade and need to get back into a logical, rational frame of mind. Taking time away from your trading session can give you the time to reflect on what happened and to stop yourself from making rash decisions that could worsen the situation.
• Reviewing and Learning from Your Trades: Instead of winning back the money you lost in a bad trade, it’s best to take your lumps and learn from your mistake by reviewing the trade and understanding what went wrong. Experience can be the most outstanding teacher—the more you know about trading mistakes, the better off you’ll be in the future, applying these tough lessons to future trading sessions.
• Practical Steps for Calming Down After a Trade: You can learn to control your emotions by creating a work environment that helps you to reduce emotional reactions. Here are some steps to maintain a steady equilibrium, even after a bad trade.
• • Take a break from your session—consider going on a walk to calm yourself down.
  • Use journaling to your advantage by recording how you felt after each loss—it can help in the future when facing similar situations.
  • Meditation is an excellent way to calm down after a nasty session and encourage improvement.
  • Reviewing past successful trades can encourage traders to remember the times they succeeded and some steps to get there.

Limiting Losses in the Main Key to Success in Options Trading

There are times when options trading can become risky; it’s important to know when to walk away from a bad trade to preserve your money and limit potential losses.

• Pinpoint the emotional traps like fear of missing out, laziness, or overconfidence, which could lead to you holding onto trades when they’re past their prime, and replace those emotions with logic and rational thinking.
• Remember the critical warning signs that trade is souring (using technical analysis is super helpful here).
• Stick to a disciplined exit strategy, which involves deciding how much profit you’re willing to make or how much loss you’re willing to take on each trade (risk management).

Preserving capital is critical to long-term success. Stop the bleeding in your portfolio and trade losing positions as quickly as possible to move to more profitable trades. Apply the principles in our guide to trading strategies for the best effect!