To close or not to close, that is the question. Whether 'tis Nobler in the mind to sufferthe Slings and Arrows of outrageous Losses,Or to take Arms and sail the Sea for profits ...The Men's Wearhouse Inc. (MW) is such a stock, as I noted on Monday in an update to the original entry posting explaining why I wasn't closing my bear position right away upon the chart giving an exit signal.
This was a fast move, one that went to "outrageous Losses" in 15 minutes without any news to explain the movement.
The position is made up on vertical credit spreads expiring May 19. I've found with such option spreads that it's often better to wait rather than act immediately upon a close signal.
In Monday's update I proposed a rather simple rule, based on very near term resistance, to determine when to close. I've since done some more work on an exit strategy and have decided to go with the tried and true:
When in doubt, calculate the risk, the reward, and the odds, and Fortune will smile upon you.
The risk is my potential loss now versus my potential loss at expiration.
I used implied volatility on MW to calculate one standard deviation either side of the current price for the next week, a timespan that gets me close to expiration.
The one standard deviation calculation says that options are pricing in confidence that 68.2% of trades will fall between the two price boundaries, in this case, at the time of my calculation, $33.06 and $36.68.
Regular readers will recognize this method as a recurring element in the analyzes I do each day.
In the case of MW, those boundaries lie almost double the average range, the distance the stock has traversed on average over the past 20 days, from the current price.
The odds of the stock moving in either direction within that range are theoretically even over such a short period of time.
I next calculate my loss now and at expiration at the high boundary, and the same at the low boundary, and see how waiting for expiration worsens or improves my risk at those boundary prices.
Remember, it's a bear position.
If MW continues to rise (bad for bears) to the upper boundary, $36.68, my risk will worsen by 26%. If it falls to the lower boundary (good for bears), then my risk will improve my 82%.
Weighting the odds by the change in risk means that waiting puts the odds heavily in my favor, about 3:1, compared to closing now.
And so I shall wait, hanging on to MW until closer to expiration.
This way of analyzing isn't appropriate for all sorts of positions. Had I held short shares in MW, I would have closed immediately upon the exit signal. Same thing with long puts, which have pretty much unlimited risk.
But with vertical credit spreads, I have a defined maximum risk and also maximum reward. So I can work with mitigation without fearing a major impact on my resources.
References
My trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.
At several points in my analysis I use the number 68.2%. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.
Disclaimer
Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.
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