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Stop Loss - Introduction
Stop loss is selling out of losing position when it is deemed to have little chance of turning around profitably or that when an options trader's predetermined loss limit for that trade is met. Sounds really simple and straight forward, right? Simply sell when things are not looking good for your position. Fortunately or unfortunately, in options trading, there are many ways of performing this action of stopping loss. In fact, so many ways that almost all options beginners are bound to get confused on what they are and how to use them.
This tutorial shall explore in depth what stop loss means in options trading and the different stop loss methods made available by most options brokers.
What Does Stop Loss mean?
The term "Stop Loss" simply means stopping a position from losing more money. For instance, you have a bullish outook on QQQ and you buy its call options for $1.50. However, instead of rising, the price of QQQ begins to drop and the value of your call options drop to $0.50. You decide that that is as much loss as you are willing to bear for that trade and you sell the call options to salvage the remaining $0.50. That is a stop loss action.
Sounds pretty straight forward until you consider more customized actions such as setting your stop loss point based on the price action of the underlying stock instead of the options price, allowing the broker to automatically track and sell the options position only when it pulls back a certain amount from its highest price.
Options trading is truly the most versatile way to trade in the world not only due to the fact that options are the most versatile trading instruments in the world but also due to the fact that options brokers have come up with so many advanced, customized solutions for entering and exiting options trades and that includes many advanced and customized ways to stop loss.
In general, stop loss in options trading can be "Stock Price Based" or "Options Price Based" and they can either be manually or automatically executed.
The Simplest Stop Loss Method in Options Trading
As you can see from above, there are many ways of executing stop loss in options trading but if you are executing simple Long Call or Long Put options strategy, there is a way to ensure stop loss, losing only a maximum of your predetermined loss amount, right from the onset of your trade; Use only your intended stop loss amount of money for the trade! This means that if you do not wish to lose more than 1% of your portfolio on any one trade and 1% of your portfolio is $1000, you would then buy your call or put options using only $1000. When you buy options in a Long Call or Long Put options strategy, your maximum loss is limited to the amount of money you use in buying those options. This means that in the worst case scenario, the options you bought expire worthless and you lose all the money you use toward buying them, nothing more. As such, if you use only as much money as you are willing to lose on a single trade, you can never lose more than that amount, effectively, putting on a "stop loss" for your portfolio right from the onset.
Of course, going strictly by the definition for stop loss, which is to set up order or orders in order to stop a position from further losses, this method isn't a real "stop loss method" per se but rather just sensible position sizing and trade planning which are essential steps in options trading. However, this is truly the simplest way beginners to options trading can predetermine maximum risk with complete certainty.
Options Stop Loss: Stock Price Based or Options Priced Based?
When you trade stocks, your stop loss decision can only be based on the price of the stock. However, because options are derivatives and derive their value from their underlying stock (or asset), their value can change as long as the price of the underlying stock changes. This happens even without the options themselves being traded. Stock prices only change when the stock gets traded but in options trading, options price can change with changes in the price of their underlying stock without the options being traded at all (this is measured by the options greek "Delta"). This opens up the possibility of basing the stop loss of your options position on the price of the underlying stock instead of the price of the options themselves. This is known as Stock Price Based stop loss policy.
Stock Price Based stop loss policy simply means selling your options position when the price of the stock is deemed no longer favorable for the outlook of your options position. Here's an example:
Of course there is the more traditional way of making your stop loss decision in options trading based on the price of the options themselves. This is extremely useful when you wish to set a predetermined maximum loss per trade. This is almost exactly the same as trading stocks apart from the fact that modern options brokers give you plenty of ways to customize this seemingly simple stop loss policy to your individual and specific needs.
Options Stop Loss: Manual or Automatic?
Manual stop loss simply means monitoring your exit point and then executing the stop loss trade manually when it happens. This could be extremely time intensive as the trader would have to watch intraday price action intently and also risk holding positions overnight with no protection (stock price or option price could open the next day with a huge gap that exceeds your stop loss expectation.).
Manual stop loss not only applies to an options price based stop loss policy but can also apply to a stock price based stop loss policy. This done by executing your stop loss when the price of the underlying stock exceeds the price which you have predetermined in your head (or written down on paper) as the stop loss point.
In both stock price or options price based manual stop loss, options traders simply sell the position using either a Limit Order or a Market Order (read sections below for explanation) without putting them on beforehand and is frequently used in day trading.
Manual stop loss is of course discouraged for retail options traders due to the obvious drawbacks and risks described above. On top of that, manual stop loss also engages the emotions of the options trader at the moment of execution and may result in the options trader not selling the position due to fear or greed even when the predetermined stop loss point is reached.
Automatic stop loss is placing your stop loss orders before they are actually reached, typically right from when the options positions are filled, so that your specific stop loss policy can trigger automatically when stop loss conditions are met. Automatic stop loss can be as simple as setting a Stop Limit order for your options position or as complex as selling your options positions only when the last price of its underlying stock reaches to, above or below a certain trigger price. Automatic stop loss methods includes (but not limited to) the basic Limit Order, Stop Limit and advanced orders such as Trailing Stop Loss and Contingent Orders (also known as "Conditional Orders"). This is most commonly used by all systematic options traders, including swing traders, position traders and day traders (learn more about the different options trading styles).
Options Stop Loss: Limit Order
A limit order is a simple stop loss method that tells the options broker to sell the options position at the specified price or better. Limit orders are best used for manual stop loss policies due to the fact that limit orders override all other existing orders and queue the options position for sale in the options market instantly. If a limit order is set too far away on a thinly traded options contract, it could even lure Market Makers to set the price of that option down to match your lower order before bringing the price back up to the prevailing market price. As such, limit orders are rarely used as an automatic stop loss method in options trading where the order is put on the moment a position is put on.
Options Stop Loss: Market Order
The problem with using the limit order above is that you are telling the broker to sell the position at $1.00 or better. This means that you could miss the whole exit trade if those call options dropped below $1.00 before your order is completed and never get back up to $1.00. By using a market order, you are telling the options broker to fill at any price the market is offering at the moment (market price) so that the order is filled as quickly as possible. Using this order means that you will never miss your stop loss trade, however, it also mean that if the market price happen to be very bad at that time, you might get filled at a price lower than you expect.
Options Stop Loss: Stop Limit
Stop limit is a simple automatic stop loss method based on the options price. This kind of order has been used much earlier in stock trading and are more familiar with stock traders turned options traders. A Stop Limit is simply an order to sell the options position at a specified price when the price of the options reach the price specified in the Stop Limit order. A stop limit order turns into a limit order at the specified price when triggered. This means that it will only fill if the price of the option is at or better than the price stated in the stop limit order.
Options Stop Loss: Trailing Stop Loss
Trailing stop loss is an advanced order type which automatically tracks the highest price an option has reached within the lifespan of the order and sell the position automatically if the price retreats by a certain monetary amount or percentage. As the trailing stop loss system tracks and sells an options position when prices retreat by a predetermined amount from its peak price, it is not only a stop loss method but also a profit taking method. The trailing stop loss order can be triggered based on both stock price or options price so it serves the options stop loss purpose of both stop loss methodologies.
Learn more about Trailing Stop Loss.
Options Stop Loss: Contingent Orders
Contingent orders, also known as Conditional Orders, are extremely advanced automatic orders that can be used for stop loss as well as entry or to automate any kind of trade or position management. Contingent orders simply tell the broker to execute a trade or a series of trades contingent upon the fulfillment of certain predetermined criteria. Indeed, every single parameter of contingent orders can be customized to perform exactly what you need. In fact, very cleverly designed contingent orders could even take care of entering an options trade when the stock price reaches a certain price and then immediately trigger a trailing stop loss or another contingent order for stop loss after that position is filled, completely automating your entire options trade! Contingent orders are most commonly used as automatic stop loss based on stock price by selling the options when the stock reaches the predetermined stop loss price.
Learn more about Contingent Orders.