What Is a Follow-Up Action?
A follow-up action is any subsequent trading that affects an established position in a security or derivative, including hedging and other risk controls. Follow-up actions are taken to change the amount of exposure an investor has in a position, or to limit a strategy's losses or profits.
Understanding Follow-Up Actions
The dictionary defines a follow-up action and an action or thing that serves to increase the effectiveness of a previous one. When applied to investing and trading, this means adding or changing a position or strategy to revise its risk profile or expected returns.
For example, an investor who is long in shares of Company XYZ may be nervous about future losses. He or she could take the follow-up action of purchasing a put option for the stock, which would minimize losses in the event of a downturn. The converse may also be effective. Using the now-hedged position in Company XYZ, if the stock price rises several points, the put option may be sold to recapture part of the original premium paid. Because the strike price of that put option is now deep out-of-the-money, meaning it is far below the current price of the stock, it loses its efficacy as a hedge.
The holder could also roll the out-of-the-money option into an at-the-money option, with a strike price at or near the current price of the stock. It will cost money to implement, raising the total cost of the hedge, but it is a follow-up action that protects the gains made since the purchase of the first option. With more complex options strategies, such as straddles, when the underlying security moves in one direction, the holder may close the option that would profit with a move in the other direction.
Follow-Up Actions as Profit Makers
Follow-up actions need not be hedges, only. A very simple example would be adding to a winning position. A stock investor buys 500 shares in Company XYZ for, say, $35 per share and the stock rallies to $40 per share. This suggests that the investor's projections were correct and the stock leans bullish. By purchasing a second lot of 500 shares at $40 per share, the investor can now be more confident that the stock is strong. In contrast, he or she could have purchased 1000 shares at $35 per share originally. This would put more money at risk in a stock that has not yet proven itself in the marketplace.
In a sense, a stop-and-reverse strategy is also a follow-up action. Let's say that the investor bought XYZ at $35 with a $5 stop and the stock does fall enough to trigger that stop. The investor may now believe that the stock is not bullish as first thought and, indeed, is now bearish. The investor can take the follow-up action of closing the original long position and opening a new short position.