Limiting losses is one of the two major elements of successful risk management (the other is correctly sizing a trade). When trading stock, the most popular method is to establish a stop-loss order.
Let’s say you own 200 shares of a speculative stock. You believe its future is bright, but over the short-term, there is less certainty. You paid $19 per share and are willing to risk $300 on your belief in this company. To satisfy your need to own shares and simultaneously limit risk, you place a stop-loss order with your broker.
The price is $17.50. The order is to sell 200 shares, at the market, if and only if the stock trades at $17.50 or lower. Under normal market conditions, if and when the stock trades at your stop price, you collect approximately $17.50 for your shares, limiting losses to $300.
This method works most of the time. But there are two situations in which it doesn’t do its intended job.
1. If there is bad news and the stock gaps lower one morning, the first trade of the day will trigger the stop, and that price could easily be far lower than $17.50.
2. In rare instances (May 6, 2010, for example), bids can disappear in an instant and a market order to sell can be filled at an unbelievably low price.
Stop Loss Orders and Options
Despite its drawbacks, many investors believe in using stop-loss orders when trading stock. And it’s natural to want to apply the same stop-loss order technique to option trades. But options are not stocks and must be traded differently.
There are many factors that go into the pricing of an option and you may be stopped out of the trade because of something totally irrelevant (and temporary).
If you own an option and the implied volatility (IV) implodes, your stop-loss price could easily be triggered, even if the stock is performing to your satisfaction. And you own the option based on your expectations (hope) for the stock price.
If you sell an option, you can set a buy-stop order. If the stock trades at that price or higher, the options are bought at the market price, limiting losses.
Because a news event may result in a sudden — and temporary — expansion of IV, with option prices moving higher, your stop-loss order may be executed. Again, even when the stock is performing well
There are other problems. For example, how would you want your stop order to be triggered? Does your broker offer a choice, or is there only one method?
You may prefer that the option must trade at, or through, your limit price. That’s how a stop-loss order is triggered when trading stock. If your option is thinly traded, the option may not trade for hours, and that defeats the purpose of a stop.
Do you want it triggered by the bid price, the ask price, or perhaps the bid-ask midpoint? There’s danger here. Many times the bid/ask spreads become very wide. That may be the result of a news story whose implications are not yet understood. Or a computer glitch may suddenly widen the markets.
Do you want your sell-stop order to be triggered when the bid reaches a certain low price? That can happen at any time the markets widen. The same problem occurs if you use the ask price to buy back short option positions.
A bid/ask spread can occasionally move from $1.60 bid, $1.90 asked to a 40-cent bid, $4 asked. Even if that lasts a few seconds, do you really want to sell at 40 cents or pay $4? With electronic trading, that’s exactly what happens. I’m sure that’s not what you had in mind when using a stop-loss order.
Stop Losses and Spreads
What about a stop for a spread position?
That’s even worse. If your order is triggered, you would pay the offer to cover your short and sell the bid to dump your long. That’s very costly, unless the bid/ask spreads are very tight.
Then there’s the additional problem of knowing how to trigger a stop loss on a spread. Unless your broker’s computer can monitor the exact spread, it’s impossible to know where that spread is truly trading. The price of the individual legs doesn’t represent the spread price.
There are far too many pitfalls to using a stop-loss order with options. If you must use them, place the stop on the price of the underlying stock, and not the option. When triggered, the option position will be closed “at the market.” That’s not good, but it’s a bit better than using a stop-loss order on the option itself.
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