The Truth About Stop Orders

Last month

In my last article I showed just how easy it is to determine where to place limit orders to ensure the highest chance for success with any Options-Intelligence trade.  By utilizing our extensive performance data and statistics calculator on the performance page, traders can quickly find the historical, statistical probability for a trade to reach a specified gain.  Armed with this information, traders can position themselves to make the most out each Options-Intelligence trade.  Unfortunately, even well researched limit orders do not guarantee success: All too often traders prevent their positions from ever reaching limit prices by placing stop loss orders.

Stop using stop loss orders

Stop loss orders are an overused, ineffective means to mitigate risk.  While their name implies some ability to stop or mitigate loss, this could not be further from the truth.  For options traders stop loss orders are literally the exact opposite of limit orders. Where limit orders put traders in an offensive position, stop loss orders put traders in a defensive position. Where limit orders are used to lock in profits, stop loss orders are used to lock in losses.

How stops are supposed to work

In practice, stop loss orders are entered at an amount below the bid price of an option and are used to trigger a sell order should the bid price of the option fall to the stop loss price.  Typically traders determine their stop loss price by choosing a dollar amount of their position or portfolio that they are willing to lose. For example, if a trader has a $10,000 position in AAPL calls, he/she may be willing to accept a $2,500 or 25% loss in the event that AAPL falls rather than rallies.  The trader would therefore set a stop loss price at 75% of the current bid price of the option.  In this scenario, the stop loss order will trigger when the bid price of the option is at or below the stop loss price thus “stopping the loss” at 25% of the total investment.

What really happens

In reality, stop loss orders merely constrain the option from moving freely.  Traders must remember that options are extremely volatile, highly leveraged derivatives. Unlike other trading instruments, options require room to perform.  As a general rule, options at or near the money with a week or less of time value will appreciate and depreciate approximately 40 times the amount of the underlying asset.  Because of this relationship, the option will have approximately 40 times the volatility.  If an option position is constrained by a tight stop loss order, it has a high probability of triggering a sell order due to the volatile nature of its valuation.

Let's be honest for a moment

Traders who use stop loss orders are primarily motivated by fear of losing money from picking the wrong direction.  Typically, traders are thinking the following:

  1. I am afraid to lose more than X dollars on this trade.
  2. If my position drops X percent, I am afraid it will continue to drop.

Expert traders will quickly identify the problems of this rationalization.  First and foremost, traders who “are afraid of losing more than X dollars” are breaking a cardinal rule of options trading:  Never trade with money you are not willing to risk! Second, the belief that market will continue dropping after reaching a stop loss price is completely unfounded due to the nature of options.

There are several reasons traders should avoid risking funds they are not willing or able to lose, especially when dealing with options.  First, options can expire, making the potential loss for any option position 100% of the investment.  Additionally, as discussed above, options are extremely volatile.  Huge, intraday swings in valuation can quickly reduce a position to a fraction of the original investment.  Finally, risking too much money eliminates a trader’s objectivity.  When traders feel as if they have too much to lose, emotions begin to overpower logic.  As a successful options trader you do not want to make decisions based on your emotions.

There is a major fallacy in the premise that the market will continue to drop after reaching a stop loss price.  As a derivative, the valuation of an option consists of two components:  The price of the underlying asset and the amount of time left before the option expires.  This means that the buying and selling by traders in the stock market determine option valuation.  Therefore, the market has no knowledge of or concern for any trader’s stop loss orders.

Things you should consider

Regardless of the mentality, setting stops by choosing a percentage of acceptable portfolio loss completely ignores the option price.  Until this point I have conveniently left out an actual option price in our original example to illustrate a point:  The cheaper the option, the more careful traders must be with stop loss orders.  In our example, our trader could have had either of the following positions:

  1. 10 contracts priced at $10 per option (10 x 100 x $10 = $10,000)
  2. 100 contracts priced at $1 per option (100 x 100 x $1 = $10,000)

Consider the effect of a 25% stop loss order on the options priced at $10 versus the same effect on the options priced at $1.  For the $10 options, a stop loss order would be placed at $7.50, giving the option $2.50 of breathing room.  For the $1 options, a stop loss order would be placed at $0.75, giving the option only $0.25 of breathing room.  While both stop loss orders are far too constrictive, it should be easy to realize how the latter is a recipe for disaster.

A better path forward without stops

Can option traders mitigate risk without using stop loss orders? Of course!  The most effective means for traders to limit risk without stop loss orders is to reduce the total investment for all positions to a level that represents an acceptable percentage of portfolio loss.  In our example, $2,500 is an acceptable level of risk (25%) for our trader.  At only one quarter of the total portfolio, this amount is easily replenished if the trader incurs losses even in the extremely unlikely event that the total investment is completely lost.  Utilizing this method allows the trader to manage risk, remain objective, and allow the option to move (hopefully to the upside) without the risk of being stopped short.

Option traders must remember that the market never trades in a straight line. Even in the best rallies or worst sell offs there is always volatility which means large fluctuations in the valuation of options.  As an option trader looking to capture gains from positive momentum, allowing a position to be stopped out at a valley is a poor choice, especially when the next peak is often right around the corner.

I want to be very clear about what I am advocating:  My primary goal with this article is to shed a new light on stop loss orders and the trouble they can cause options traders.  When set too tightly or with no regard to the option price, stop loss orders merely cause traders to exit their positions too quickly.  These instruments can still be a viable tool; however, they must never be a trader’s primary means to mitigate risk.  Next month I hope to continue with this and related topics and reveal a better method for determining when to exit a position without stop loss orders.

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