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Using Options As a Secondary Stop Loss


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  • Using Options As a Secondary Stop Loss

    The second way to use a protective option is in conjunction with a stop. The closer an option is to its underlying asset, the more expensive it will be. It stands to reason that an option placed at a 2 percent loss threshold will be more expensive than an option placed at a 10 percent loss threshold. Whether because of account size, number of contracts placed on the trade, feeling a premium is too expensive, or simply looking for a way to stagger your trades, having a stop loss order in the first position and a protective option as a secondary stop loss can be an advantage.

    There are three scenarios that can play out.

    In the first scenario, the market is moving quickly. If a there is a tight stop loss order, say at 2 percent, then a trader can exit a losing position immediately, with some slippage. The average retail trader would then attempt to chase the market's new direction by entering a new order and quite possibly end up being whipsawed.

    A more relaxing alternative is to have the stop loss order in place at 2 percent and a protective option at 5 percent or 10 percent. The stop loss order is triggered and a loss is booked into your account. Instead of chasing the market, you wait for it to come to your protective option. If the market breaks through the strike price of your protective option, your protective option begins to accumulate profits. If the market begins to turn around at or near the option strike price, you can reenter your original futures or forex position and turn it into a synthetic options position.

    In the second scenario, the market is predictably bouncing between a consolidating resistance and support line. As traders we hope for the best, but we prepare for the worst with a stop loss order.

    In the final scenario, the market is shifting from a counter-trend to a trend. If your trade is going in the expected direction to the contract's price, then you are trading the trend. Any pullback would be considered a counter-trend. While the market attempts to choose its ultimate direction it begins to consolidate. These consolidating markets tend to be the most difficult for stops to navigate. It is quite rare for any market to move straight up or straight down. Along the way the market will pull back. Unfortunately, you never know whether the pullback is simply a market that is consolidating or there is a fundamental shift in the market's direction. Stops treat both situations the same, so when a stop is triggered you are forced out of the market, period. There is little you can do if the market was simply consolidating and it halts its move against you and begins to move in the direction of your original position. This is known as the whipsaw effect.


    Since stops are an all-or-nothing proposition, they leave little room for the market's constant consolidation and retracement behavior. This has the effect of you potentially being right about the market, but being stuck on the sidelines because you were stopped out. A well-placed option can have the opposite effect. If you place an option where you would have placed your stop, you are able to hold on to a losing futures position slightly longer. Even if the delta of the option is different from the underlying futures contract, as you lose money on the futures position the option helps offset some if not all of your losses as it gains in value. This gives you the necessary breathing room to determine whether the market is consolidating or changing.

    Finally, stops have difficulty navigating fundamental shifts in the market's supply and demand. When these fundamental shifts occur, the most benign result of using a stop is some slippage, as we discussed earlier. In the worst-case scenario you could find yourself in a lock-limit market unable to get out, with the potential of losing more money than you invested. Once a market is at the lock limit, all trading is halted until the price stabilizes. Markets can be lock-limit for days on end; all the while you have little recourse and you are racking up losses at a phenomenal rate.

    When it comes to trading, there are no fix-alls, simply substitutions. An option in place of a stop loss order is just that, a substitution. By comparing stop loss orders and options side by side, options clearly come out the winner in each scenario. Over the years the difficulty of using stops alone has been recognized. There is a clear alternative to using stops alone to manage losses-options-but it requires that you look at trading the same way that money managers do. Money managers look at the interdependence of futures and options contracts and the built-in risk management relationship that they have with one another to diminish their losses. By taking this approach they are able to use finesse and control to protect themselves from fast-moving markets, consolidating markets, and fundamental shifts in supply and demand, and now you can, too.

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