Last month I wrote about the perils of stop orders and revealed how they can be detrimental for option traders.  One of the major points from that article was the reality of option valuation.  As I pointed out, it is activity in the stock market that determines how options are priced.  For this very reason stop orders are an arbitrary and therefore invalid means to determine when an option position is a losing position (i.e. should be exited).  This does not mean option traders should be willing to accept a 100% loss on an option position; it simply means that there is a better method for making this determination.  To do that, traders must look to the underlying stock in order to better gauge their option position.

Options are derivatives which is a unique class of financial instrument whose price is derived from underlying components.  For options, the underlying components are twofold:  First, the time remaining before the option expires and second, the market value of the underlying stock or ETF in relation to the option’s strike price.  These two components, called the time value and intrinsic value (respectively), determine the value of an option.

Intrinsic value is the least conceptually complicated component of option valuation.  An option gains and loses intrinsic value based on the movement of the underlying stock or ETF relative to the option’s strike price.  For call options, intrinsic value is gained as the underlying asset appreciates in price.  Once the underlying asset has a market value higher than the call option strike price, the position has gained intrinsic value.  For example, an option position in SPY calls with a $120.00 strike price will have $1.00 in intrinsic value if SPY trades up to $121.00 per share.  For put options, the position gains intrinsic value as the market value of the underlying asset falls.  In either case, option positions with intrinsic value are said to be in the money and those without intrinsic value are said to be out of the money.

Time value is the second component of option valuation.  An option’s time value is a function of the time remaining until the option expires.  Calculating time value is very simple:  Out of the money options (i.e. those with zero intrinsic value) only have time value, so the time value remaining is the price of the option.  To calculate the time value of an option that is in the money, simply subtract the intrinsic value from the cost of the option.  Continuing with our previous example of SPY calls, we know that the option position is $1.00 in the money.  If the options are priced at $2.40 per option, this means that they have $1.40 of time value remaining.

The time value of an option constantly erodes beginning the moment the option is issued.  This erosion occurs linearly, such that it reduces the time value to zero by the end of the trading day that the option expires.  Let’s assume that the SPY calls we mentioned earlier have 5 trading days left until expiration.  If we divide the time value by the number of days remaining, we can determine the rate of erosion.  In this example, the SPY calls lose $0.28 in time value per day which is equivalent to a 11.7% loss in total value each day (based on the current price of the option $2.40).  This constant devaluation creates the basic goal for options trading:  Option traders are simply trying to purchase options which gain intrinsic value at a rate faster than they lose their time value.

Since the time value erodes linearly, determining the potential change for the intrinsic value is paramount for gauging the potential success or failure of an option position.  By developing a history with a particular stock or ETF, option traders can make better decisions about when to exit a trade based on the movement of the underlying asset and not the movement of the option position.  The most practical way to do this is to identify the potential movement in a day’s worth of trading for the underlying asset.  For example, on a typical trading day the Powershares ETF QQQQ will move no more than 1% to 1.5% in one direction.  Keeping this range in mind, it is easy to estimate an exit price based on the market value of QQQQ that signals when to sell an option position at a loss.

This exit price, which I will refer to as the point of no return, is based on the typical daily movement of the underlying asset and the number of days in which an option trader has remaining to make a return.  Finding this price is best explained via an example:  If an option trader purchases QQQQ weekly call options on Friday and is looking to profit in the following week, he/she has 5 trading days to build intrinsic value on the option.  A conservative point of no return is therefore in the -2.5% to -3% range of the market value of QQQQ at the time the trader opened the option position.  If QQQQ falls to this price point by Wednesday of the following week, it is extremely unlikely that the option position will recover from the loss since the ETF only has two trading days to recover.  If instead, the same option trader is looking to profit in the next trading day (Monday), the price point should be adjusted accordingly (for example -1%).

Developing a point of no return protects option traders from an all too common phenomenon:  Getting stopped out only to see the option position bounce back.  By knowing the typical activity for a stock or ETF, traders can establish realistic expectations for market activity and establish loss points that are truly relevant.

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 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.

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.

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.

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.

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.

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.