Trading has end goals that are different for everyone. Some look at it as a way to keep score, others as a way to prove ego, and others still as a means to an end.
Regardless of the goal, everyone has a goal to make profits. The thing about a goal like that however, is because it’s so open ended, most people never get the big profits they really wanted in the first place.
It’s easy to say I bought FB at $20. It’s a lot harder to say I’m still in FB from $20 when it’s now over $170.
How do you handle the swings that come with holding a trade for bigger profits? Whether it’s taking a trade from 1:1 to 2:1 or taking a trade from a double to a triple, to make real profits, you have to be willing to give it back without willing to go underwater on a massive winner.
The key to making larger profits is you must learn how to only trade house money.
It’s easy to say I’m in at $20 and my stops at $25 so since the stock is currently at $30 I’m home free.
However, if tomorrow the stock comes out with news that sends your stock gapping 50% premarket (EFX anyone?) and you aren’t covered then that stop does you no good.
A stop market order only means that you will be taken out at the market price if your number is reached. A stop market order does not guarantee you will be taken out where you want.
So back to our example. If you are in a stock at $20 and it’s up to $30 you’re up around 33% at the minimum.
If you’re stop is moved to $25 you’ve locked in a $5 gain and are up at least 20%; excellent job.
However, if the next day something happens that causes the stock to gap around and take a 50% bath, what will your stop end up doing?
Your stop market will simply trigger at market price once $25 or lower is reached. That means if the market opens at $15, you’re out at $15.
This doesn’t happen very often under normal circumstances, but if you’re in profits and holding a stock through earnings, FDA news, or just unlucky, you better believe it can happen.
Stop Markets are helpful, and they are used by us regularly especially starting out. The potential for these types of black swan events are rare and if you truly understand trading it’s simply exchanging risk for potential reward. Which is why a trader clicking a mouse for 30 minutes can make more than most who work 40 hours when it’s done right.
That being said however, once the trade gets enough into profit to start using house money, there are alternatives that work even better than stop markets. Enter Box Trades.
Box Trades using Options
A box trade requires 3 parts.
- Equity Shares
- Call Options
- Put Options
While it can be done from the start, it is recommended to not pursue until the trade is in enough profit to cover the cost. Doing this beforehand will eat away at profits and is only recommended under extreme circumstances.
However, lets go back to our example above. (Note: The video below shows a live example if you’d prefer video over reading). In the above example, the stock was purchased for $20 and was currently at $30.
If the same goal of $25 stop was desired, instead of using a stop market which has risks, the trader could look to purchase $25 puts roughly 1-3 months out on a long term setup or 2-4 weeks out on a short term setup.
Whatever the cost of the put, the trader would sell calls on the other end to offset the balance.
Tip: Never sell naked calls/puts. Only sell 1 contract for every 100 shares you own and round down.
Let’s say the $34 calls cost the same as the $25 puts. Noticing the calls are more expensive than the puts from the get go may be an excellent indicator where markets believe this stock to be heading.
In this example let’s assume the trader has 300 shares purchased at $20.
They want their stop to be at $25 to lock in profit now that the trade has reached $30.
By selling $34 calls and using the profits to buy $25 puts they have created a risk free box.
If the trade gets above $34 before expiration, the shares are taken away for a $14 profit or 70% Return.
If, however, the trade has a black swan event where the stock gaps against, the stop market order would result in a net loss regardless of where the stock was the day before.
The puts however would profit anything under $25 theoretically locking in profits at a $25 level or $5 per trade.
The difference between a covered call and a box trade is a covered call is used for slow stocks looking to collect extra premium, the box trade is used for aggressive stocks where you are looking for insurance.
The downside to this is that if the stock gets past $34 you’re out the shares and no longer have a position. If, however, you are doing this short term and the options expire worthless you can look to put it back on every few weeks or months and simply hold until taken out from the calls.
This is only one example of how to protect profits, but hopefully it can help shed some light on ways to protect profits other than simply adjusting a stop and hoping the news doesn’t hurt you.