Knowing when to book profits is just as important as initiating a position. This is especially true when your position is yet to generate its target returns. This week, we discuss a rule that you can use to take profits when you trade options and futures.
Understanding indecision
An underlying or its futures contract is said to be in an uptrend when its price forms higher highs and higher lows. Yet, bulls get exhausted in an uptrend. When price pauses during an uptrend, you may not know whether the bulls are temporarily exhausted, or whether the bears are slowly gaining control. If the bulls are temporarily exhausted, you may decide to hold your futures contract till it reaches your price target. But if you believe the bears are slowly gaining control, you might as well take profits, even if your price target is not reached. It is in context that you must appreciate the Doji. This is a single candlestick line where the opening and closing prices are equal or nearly equal. A Doji is useful as a signal when observed in a context.
Consider a recent price uptrend. Your long position in a futures contract or in a call option has unrealised gains. Then, the price forms a Doji, a sign of indecision. It indicates that neither the bulls and nor the bears won the battle for the day; the bulls are trying to keep control, and the bears was wrestling to gain control. In the context of an uptrend, it indicates that the bulls are tired. So, what should you do?
Long calls lose value with each passing day due to time decay. So, if you observe a Doji on the daily chart especially between the Friday preceding the option expiry week and the Wednesday of the expiry week, you should consider taking profits on your long call positions. Why? An option’s time decay must accelerate between Friday and Wednesday for its time value to become zero at expiry. Also, if bears gain control and the underlying were to decline after the price forms a Doji, you could lose a significant part of your unrealised gains. You can, however, wait for confirmation of bull exhaustion to close your futures position, given that futures do not expose you to time decay as options do. Suppose the price forms a Doji on Monday. If the futures price on Tuesday trades below Monday’s low, then consider taking profits.
Appreciate the Doji
A Doji, a single candlestick line where the opening and closing prices are equal or nearly equal, is useful as a signal when observed in a context
Optional Reading
You must be mindful of two factors before using Doji as a rule to take profits. One, the Doji must be observed on an underlying price chart when you are trading equity options, and on the futures chart when you are trading futures and index options. And two, it is possible the price forms a Doji, pauses and continues its uptrend thereafter. So, taking profits on long calls based on Doji may result in you giving up further gains.
(The author offers training programmes for individuals to manage their personal investments)
