Options and Stop Losses

Question - Options and Stop Losses

Regarding options and stop losses, what's the best way to establish stop loss protection when option trading? Should it be based on the price of the options or should it be based on the price of the related stock?

Answer

Great question, and one that doesn't get addressed often enough.

First, there are a number of drawbacks to trying to set up a stop loss based on the fluctuating price of an option.

Most options still trade in at least 5 cent increments, and the bid-ask spread for options can also be quite wide. This makes it very difficult to set up any kind of a precise stop loss - it's kind of like using pliers to remove a splinter instead of tweezers.

Also, because the price of an option is a fraction of the price of the underlying stock, even a small move in an option's price will represent a significant percentage change.

Second, there's another factor to keep in mind when considering options and stop losses. Remember that option pricing is more complex than pricing a stock. With a stock, it's essentially a matter of supply and demand, with some considerable influence thrown in for good measure by the market makers.

But an option has numerous moving parts that all influence its current price. The delta, for example, measures how much an option changes in value in relation to the movement of the underlying stock.

True, supply and demand plays a role, but there are other factors, such as changes in expected volatility or simply the passage of time (theta), that can have a big impact on an option's price regardless of what the underlying share price is doing.

So if you're going to try to set up some kind of options and stop loss protection on your trade, I think you're much better off basing it on the price of the underlying stock, not the price of the option.

But that leads to another question . . .

Are Stop Losses the Best Way to Exit Losing Trades?

I think it really depends upon the quality of your stop loss. I know there's a lot of advice out there about how you should always set up a stop loss on a stock at X percentage. Now, there's often a lot of debate about what the ideal X is - is it 8%? 10%? 15%?

To me, that's the wrong question. The real question is, should you even have a stop loss based on a percentage move in the stock price in the first place?

Let me explain . . .

If you're going to be an option trader rather than an option investor, you're going to have be proficient to some degree at technical analysis.

Do you have to be a member of Mensa and an MIT graduate? No - but you do have to recognize that trading is a short term strategy based on pattern recognition and predicting the most likely aggregate near term behavior of other traders.

So whether you use moving averages or trend lines or something else, you need to clearly identify in your mind the areas of support and resistance in an underlying stock before you ever open an option trade on it.

And then you just ask yourself one simple question: what price would the stock have to trade to or close at to persuade me that the stock's support (or resistance if you're trading the other way) had convincingly been broken?

If and when the stock hits that price - that's when you should close your trade. The most effective method of options and stop losses is to know beforehand when you would close the trade and why.

An Option Trading Alternative

Finally, if all this seems a complex, challenging, pain in the ass way to make money, that's because it is.

Well, depending on your personality, that is. Some people are absolutely made for complex or aggressive option trading strategies. Just as some people are total conservative, boring, cautious investors.

Myself, I'm somewhere in between. That's why I absolutely love Leveraged Investing.

For me, it's the best of both worlds - the excitement and sophistication of using options with the stability and Warren Buffett style track record of long term investing in high quality companies.

What it really comes down to, of course, is finding the trading or investing style that really matches your own personality.

Best of luck to you -

Follow @LeveragedInvest