Stop-Loss in Options Trading

[roreilly]

Quote from bc1:

Mr. Reilly, what are you trading in that gives an $8.50 credit on a $10 spread? Thanks.

You asked, I'm responding. But do not think that I am recommending this trade. I already said don't do this. It is just an example of an options trade where the stop loss is essentially the full amount at risk.

Sell SPY Jan 12 @ 117 for $11.11
Buy SPY Jan 12 @ 127 for $2.70

That is $8.41 in credit, margin is $10.00, maximum loss is $1.59 (excluding commissions). Obviously, the trade depends on SPY falling and falling fast. Otherwise, time decay will eat up your credit.

We can all discuss how stupid this trade is, in that it depends on calling the market exactly right, but that is off topic.

 

[dragonman]

Quote from roreilly:

I have tried stop loss orders both based on the option price and on the underlying instrument's price. I have had poor results with both.

With regard to tying the stop loss to the option price, if the bid ask moves just a little, the stop loss can be triggered without any real change in the stock.

Tying the stop loss to the underlying exposed me to changes in volatility, and market conditions so that the move in the underlying was greatly magnified before the stop loss order was executed.

I stopped using stop loss orders, and now I hedge my options positions with either a vertical or horizontal spread (sometimes a diagonal spread). I also found it helpful to consider how to roll out a position or otherwise adjust it depending on the market move.

Depending on the circumstances, I sometimes enter into what I consider a binary trade. For example, let's say I want to call a market bottom. (Side note-don't do this). I would enter into a credit spread that pays $8.50 on a $10.00 spread. Thus, my maximum loss is $1.50, but I need the underlying to move sharply to capture the the full $8.50. In this situation, a stop loss does not make sense -- you are all in, so to speak. Adjustments can be made, but they tend to make the trade even more unlikely.

Of course, we talk about options as if they are all the same. But buying a DITM call is totally different from selling an OTM call in the front month. Some specificity about what you are buying might help focus the discussion.

Thanks for the explanation. I completely agree with you regarding the "binary trade" concept as you stated it, which can also be viewed as a "built-in" stop-loss.

To answer your question, I asked my stop-loss question regarding a directional bullish strategy on stocks either through simple calls or debit spreads that are located ATM or slightly OTM. If you or the other readers have anything to add based on this information I will be happy to read it.

 

[roreilly]

Quote from dragonman:

Thanks for the explanation. I completely agree with you regarding the "binary trade" concept as you stated it, which can also be viewed as a "built-in" stop-loss.

To answer your question, I asked my stop-loss question regarding a directional bullish strategy on stocks either through simple calls or debit spreads that are located ATM or slightly OTM. If you or the other readers have anything to add based on this information I will be happy to read it.

I tried trading at these same instruments with stop losses, but I found that the stop losses were ineffective. ATM and slightly OTM calls have the greatest time premium; whether the underlying assets moves up or down, or does nothing, the time premium must go down. Time premium is lower both OTM and DITM, and decays over time.

That factor magnifies the underlying's moves.

The inherent leverage in those options is a double edged sword: a two percent rise in the underlying can return 50%. Of course, that also means that a two percent fall returns -50%. If you could avoid the -50% part of the equation, you would have a holy grail system, that would produce an absurd ROI.

If you are trading such volatile, leveraged instruments, I would be highly focused on position sizing, and would not invest more than .5-1% of my capital in any single trade. If you are looking at stop losses for these, than you are probably trading more than 1% of your risk capital.

When I first started trading options about 15 years ago, I traded ATM and OTM debit spreads. I ran my $10,000 up to $30,000 in two months, and I thought I was a genius. A bear market correction devastated my account, because I was risking about 10% of my risk capital on each trade, and for each 50% loss, it takes a 100% gain to make it up. Part of my trading tuition.

Safe trading!

 

[Quickless]

Using stops – possibilities

1. You have to leave a position unattended.
2. You are trading multiple positions in very fast moving markets.
3. You have trouble exiting losing positions.

The most important aspect of using a stop is that there is the theory and the practice. Meaning how a stop is intended to work or your understanding of how it works, might be different from the actual result. Usually in these cases you will have no recourse.

The truth – stops are a tool. You are going to have to go out there and see how they work.

 

[Grinder]

Quote from spindr0:

Sometimes the long puts are already in place since the initial position was a vertical. It finishes just ITM so the collar occurs by adding the short calls.

Spin,

Are you saying the initial position was a married put or somekind of short diagonal put spread?

 

[IgorVI]

The way I set a stop loss is simple. First you need to determine how much are you willing to lose. After you figure that number out look at the deltas of the option you're looking to buy or sell. Now divide your loss amount by deltas, that's how many points underlying can move against you before exiting the position.
Example:

ABC trading at 340.00
You feel like 330 is a strong level of support and willing to give ABC 10 points to the downside before exiting this trade for a loss. Let's say you decided to buy a call as you think that ABC will bounce. ABC 350 call has a delta of 40, that means if ABC goes to 330 (your stop-out level) you're out 400 bucks. Now to determine position size, say you have a 50K portfolio. You're willing to risk 1% per trade (50,000 x .01) or 500 bucks. That tells you your position shouldn't be larger than 1 contract. I use this method at options4income.info if you have questions feel free to reach out to me.

Just my 2¢

 

[spindr0]

Quote from Grinder:

Spin, Are you saying the initial position was a married put or some kind of short diagonal put spread?

It could start out as anything - naked put, vertical, spread, diagonal, etc. I'm more concerned about not losing than the winning which I believe to some extent, takes care of itself.

My comfort zone is building positions as price allows. Here's another example. Suppose my comfort zone with XYZ is 10 short puts. I sell em. If XYX moves up a pt or two, I might buy 10-15 long puts - a lower strike creates a vertical or diagonal and same strike later month creates a calendar with some extra long legs left over. If XYZ then drops, I'll sell more puts going up to net short 10 again. Sometimes the stock hits a channel and you can build a larger position at good (legged in) prices. If not, you have your intitial comfort zone position. It's an incremental approach.

You can make the argument that after the initial rise, you should take whatever profit you have and find another potentially profitable position. That's every bit as valid. There's no correct answer. How one uses options and trades is a personal thing.

 

[Grinder]

thx for sharing.

 

[trader198]

never use stop loss in option. even in stocks, I do not trade stocks.
only use stop loss to trade futures.

in stocks, if you are investors, stop loss does not make any sense, even with intra-day, there are haltings/pendings, so stop loss does not make any sense. bad things happen then happen. stop loss suppose the market runs in trend or some kind of range-band ways, but in reality, 80%+ stocks do not run in that way, gap down/gap up, trend a while, then suddenly disappear, always do those naughty things.

the sure way to limit loss is option. for example, last week, if I shorted INHX at 10, then overthe weekend, the market gapped to 24+ (a buyout), you mean stop loss, a laugh, I will lose 14 bucks a piece, even my stop loss is at 11. but if I bought put strike 10 with 0.8 bucks, I just lost the 0.8bucks, that is all. I can totally control my loss to what I want to.

since option is stop loss built in. it is not necessary to do so. if I want to long something, and limit my loss at 1k, then I bought 1k call option, sleep tight, if my 1k doubled, get out half, then let another run til almost expiration or my trading idea invalid(free ride, risk free), so I can make the maximum profit. if my 1k down to almost zero, do not bother to do anything until expiration, if lucky, cooked duck fly, then happy about that, if not, feel happy too since I follow my trading plan, why bother being sad.

option is just a tiny partion of the underlying, plus volume is noramlly low, it is pretty valitlie with large bid/ask spread, it is fruitless to use stop loss.

I normally use stop loss to trade futures in those technically tradable markets, that make sense. in future market, it is almost 24hr open, beyond circut breaker, 15minutes and half minutes trading haldtings, volume are awesome good, news release will not stop the market. all time are good for stop loss. that is why most people trade futures are day traders.they use stop loss to control their loss.

 

[IgorVI]

Quote from trader198:


option is just a tiny partion of the underlying, plus volume is noramlly low, it is pretty valitlie with large bid/ask spread, it is fruitless to use stop loss.

If you're buying ITM options then YES there's intrinsic value so it has a portion of underlying, but if you're buying an OTM option that has nothing but time premium and that option is overprice already that's bad bet. It's better to set a mental stop, if ABC goes to X then exit the option position. But I do agree with you that with options you can manage you're risk better then buying underlying and having overnight or event risk.