How to Price and Trade Options: Identify, Analyze, and Execute the Best Trade Probabilities, + Website

CHAPTER 7 Exiting Trades

The area of trading that receives the least attention (and has the least intelligible educational material available) is “when to exit a trade.” One of the reasons for this lack of a strong body of knowledge on the topic is that few traders truly understand the math behind it. Most traders exit by “feel” instead of by mechanics. They stubbornly refuse to take a loss and believe that makes them better traders in the end. As a person who believes strongly in the power of math, I would like to change that. So we will discuss what a proper mechanical strategy looks like and how to design one. We will also look at when it is allowed to deviate from the plan and when it is essential not to deviate. This will take place in the context of a strategy with a positive expectancy. (A positive expectancy means that with a high enough number of occurrences, the probabilities predict we will be profitable.) We will look at the three situations that lead us to exit a trade and dissect what each means to our probability assumptions.

The Variables

What variables must we solve for (or at least understand) to create a positive expectancy trading strategy? Though it sounds like a difficult question, it really has a simple answer. Even traders who work by gut feel have an understanding that the “edge vs. odds” relationship is critical to success. In other words, the greater the odds of success or the bigger the edge in the trade, the bigger the risk you should take on ...