TSC Options Forum: Stopping Options
Steven Smith
09/06/03 - 09:26 AM EDT
Are there stop strategies for option positions? I have long put and call positions and am looking to protect myself from losses.
-- C.A.
The first and best way to protect yourself from losses is to always be right. Since that's not possible, the next best tool is to employ stop-loss orders. When trading equities this is fairly straightforward: pick the price at which you want to "get out" of a position. When the stock actually trades (not merely bid or offered) at the specified price, the order is executed. Note the important difference between a stop loss and a stop-loss
limit. The latter will only be filled at that specified price. Dealing with a thinly traded issue, fast market or a gap situation may result in the stock trading through the limit price, leaving your stop loss unfilled.
This brings us to the first obstacle in using stop prices for options. Most options markets are much less liquid and have wider spreads than the trading in underlying shares. This makes it difficult to set a stop-loss price that will result in what you deem a "fair" execution price. It's important to understand the distinction between what is designated an acceptable loss and what is actually delivered.
For example, assume you shorted XYZ 30 calls at $3 and are willing to risk $1 a contract. A buy stop loss at $4 would be entered. But be aware: Once the call trades at $4, your buy-stop becomes a market order. Now, if the $4 level traded because XYZ is moving higher, don't be surprised to see the call next quoted "$4.25 bid/offered at $4.75," which means you'll be filled at $4.75 for a loss that's 18% greater than anticipated.
Avoid Slipping on the Fudge
One alternative is a contingency order based on the price of the underlying shares. For example, assume you decide that if XYZ trades above $31, it's no longer wise to be short the 30 calls. You can enter an order that states "if/when XYZ stock trades $31, then buy to cover the call options at the market."
The advantage is that it uses a more accurate assessment of technical support and resistance levels, providing a closer read on the "real" price action as opposed to a derivative, which leads to more timely executions.
Since options prices move in response to the underlying, they have an inherent delay and inaccuracy built in to the bid/ask in the form of wider spreads. This is sometimes referred to as "slippage" but I'll call it the "fudge factor" that market makers require for keeping risk low and profits possible. By tying an option stop-loss order to the stock price, you'd be anticipating rather than reacting to the options price movement; hopefully, this will result in a better execution price.
Another variation would be to use a stop based on a percentage change in the price in the underlying. For example, should the price of XYZ rise 5% the buy-stop on the short call will be activated. This is most often used on a trailing-stop basis, i.e., as the price of the underlying moves in your favor, you maintain a 5% price movement from the daily close as the price trigger.
The Order of Things
Of course, none of this matters if your broker tells you they don't accept such things as stops on options, contingency orders or percentage trailing stops. If you trade options with any regularity, find a broker that does accept them. Some names include Interactive Brokers, ThinkorSwim and OptionXpress.
They'll generally accept the above-described order types when dealing with a single strike execution. And while the spread execution has improved thanks to more advanced software, I don't know of anyone accepting stop-loss orders on multistrike orders. Nor would anyone want to use them. Market liquidity, lag time and slippage would only be exaggerated with more elements added to the option position.
Another type of contingency order (which can be layered on top of the "if/then") is a "one triggers other," or OTO. This means the execution of one order will activate the execution of another. For example, getting back to our reader who owns both puts and calls, even if it's not designated as a strangle, one could set a stop loss on the call option at a specific price (based on either the underlying or the option itself) and once it is filled, an OTO order would cause the put options to be covered at the then market price.
Oy ... so much. Better to just try to be right -- it'll save you a lot of aggravation, to say nothing of money.
