Options Traders Should Learn To Use Stop Losses

In this article, we discuss that options traders should learn to use stop losses and elaborate on:

  • The rationale of using stop loss orders
  • Specific examples of stop loss orders being used
  • The advantages and disadvantages of stop loss orders

A stop loss order is an order that is executed with the intention to limit losses on long positions or short positions.

With a long position, a stop loss order is a sell to close order once a specified price is reached. When that specified price is reached, a market order is executed. Do take note that the order may not be filled at the stop loss price specified. Instead, it may be filled at a less than desirable price due to significant price moves in the form of gap ups or downs.

With a short position, a stop loss order is a buy to close order once a specified price is reached. When that specified price is reached, a market order is then executed. The order may not be filled at the stop loss price specified due to large magnitude price moves in the form of gap ups or gap downs.

 

An example of a stop loss order for long positions

A trader buy Dec 40 call options at a price of $2 per contract on the underlying security of ABC Corp. The options were at the money. The trader was betting that the price of ABC Corp would rise in the near term. However, his predictions were wrong. His stop loss order was triggered at his specified price of $1.50. However, the trader only managed to sell to close the position at a price of $1.40.

The order was filled at a price of $1.40 as the executed order became a market order after a specified price of $1.50 was breached.

An example of a stop loss order for short positions

The whole idea in options trading or any form of investment is to buy low and sell high. In the case of short positions, it is to sell high initially and to close the position by buying low. Hence, stop loss orders occur at prices higher than the sell to open price.

Let us examine an example. A trader sells a naked call at a price of $2 with the prediction that the price of the underlying security will move downwards and that the option will expire worthless at $0. When that happens, although he need not buy the option back, he is essentially buying at $0 and selling at $2. Of course when considering the trade, he may have put a stop loss order of $2.50. If the price of the option reaches this price specified by the options trader, he will be “kicked” out of the position with a buy to close order. When the $2.50 price of the option is reached, the stop loss order triggers a market order that buys to close the short position at the next available market price. As a result, the trader’s order may be filled at $2.60.

The exhaustion gap

The exhaustion gap seen here is an example of a gap up. There is a sudden spike in price without an orderly adjustment upwards. In this instance, a stop loss order which is activated in turn activate a market order which may be filled at a less desirable price.

Common gap

There are gap ups and downs seen here. Again, these sudden price movements may trigger a stop loss which is converted to a market order that is filled at less than desirable prices. This is due largely in part to disorderly adjustments of price.

Advantages and disadvantages of stop loss orders

Stop loss orders are specific orders which are triggers a market order. A market order accepts the available price in the market at that time. These market orders may be filled at less than desirable prices due to large magnitude price movements. However, stop loss orders are a necessary tool for preventing runaway losses. At the very least, it gives an options trader an estimate of the potential maximum losses in a trade. This is particularly so when a trader establishes a naked position in put or call options where the losses can be tremendous.

Read also : Types of orders that option traders can use

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