Could using options or using stop orders be the better method to mitigate risk in a trader’s position?
Let’s first define a stop order. For an existing open short position in a futures contract, equity or ETF, an order to buy is placed at a specific price above the current market price in order to liquidate the position. For an existing long position in a futures contract, equity or ETF, an order to sell is placed at a specific price below the current market price in order to liquidate the position. As soon as a trade takes place at that specific price or higher, the stop order is triggered. The converse is true for an existing open long position. The vast majority of stop orders are market orders upon being activated, but they also may be entered as limit orders. The stop limit order ensures a specific price while at the same time defeating the original purpose of the order. In a runaway market, it might never be filled.
Let’s use BIDU, known as the "Chinese Google," as an example. BIDU is shorted at 139. A stop loss order is placed at 141. The tolerance for loss is less than two percent. If BIDU drops to 135 during the day, the stop order can be lowered to 137.50, thereby guaranteeing a profit. If BIDU continues to head south, the stop order can be lowered continuously. If the BIDU short position is bought back at 133, there is a profit of $600 for each round lot (100 shares) that is shorted.
An alternative to placing a stop order above the market would be to purchase a call option near the 141 price level. One disadvantage to using a call option is the lack of precision in using the strike prices. There is not a 141 strike, but there is a 140 strike. A call option acts as a built in stop order. Because the owner of a Nov 140 call has the right to own 100 shares of stock at 140, the losses are stopped out at 140. The difference is that a premium must be paid for the use of this type of stop order. In this case, BIDU Nov 140 calls would cost 9.20 ($920) per option.
The premium consists of both expiration value (sometimes referred to as intrinsic value) and time value (sometimes referred to as extrinsic value). The expiration value is the in-the-money portion of the option premium. At the end of the expiration cycle there is no time value left; only the expiration value that is in-the-money remains. Expiration value is an objective measurement. Time value is subject to the whims of supply and demand. That throws an extra wrench into the works. Because the Nov 140 calls are above where the stock was sold, the premium consists purely of time value. If the BIDU short position is bought back at 133, the $600 profit per round lot still exists. There is a loss in the call that was purchased, however. The Nov 140 call probably would lose about 2.50 ($250) per option. The other disadvantage of using a call vs. a stop order is that the stop order can be lowered continuously at a specific price. The call protection could be lowered to 135 by selling out the 140 calls and purchasing the 135 calls. Once again the uncertainty of the potential change in the price level of time value comes into play.
Now let’s take a look at what happens when the stocks rises after the short position at 139 is established. When BIDU trades at 141 or higher, the stop order is activated. If BIDU is bought back at 141.20, a loss of $220 per round lot is sustained. If the call position is unwound at the same time, then the $220 loss on the stock is softened by the $100 gain in the call that was purchased. There is another very attractive benefit to using a call in lieu of a stop order. If BIDU touches 141, there is no obligation to liquidate the position. Let’s say that it runs up to 141.50 and then reverses course and heads south. If it heads all the way down to 133, the stop order would have lost $220 while the call option strategy would have netted $350.
Let’s review a trade with a stop order placed 5% below the point of purchase. BIDU is purchased at 145. The stop loss order is triggered as soon as BIDU trades at 137.75 or lower. Twenty-eight days later that happens and BIDU is sold at 137.50 for a loss of $750 per round lot. Instead of a stop order being placed, a BIDU Dec 135 put is purchased for 5.50 along with the purchase of the stock. The time value of the put has eroded over the 28-day period so that its premium has remained at 5.50. If the drop in BIDU occurred earlier, the put would have retained more of its value. Once again, time value rises and falls constantly so the 5.50 example probably would be a higher or lower number. If BIDU rises 5% to 152.25 over a 28-day period of time, the stop order strategy results in a profit of $725 per round lot. The Dec 135 put probably would be priced around 1.00, reducing the overall profit to $275 per transaction.
Let’s say BIDU descends below 137.75 14 days after the stock is purchased. BIDU reverses course after bottoming out at 136 and heads up to 152.25 14 days later. The stop order loses $750 while the options order nets $275. Because we are looking at a longer term scenario, what would happen if there is a gap opening where the stock doesn’t move 5% but rather 30%? BIDU opens at 101.50. The stop order allows the long position to be liquidated for a 43.50 loss on the opening. The Dec 135 put probably would be worth about 34.00. That would result in a net loss of $1,500 per transaction vs. $4,350 per transaction.
Other than using a stop order or an out-of-the-money option for risk control, there is a third alternative. The BIDU Dec 135 call can be purchased for 16.00 and the BIDU Dec 155 call can be sold for 5.50 for a net price of 10.50. The maximum loss on this position would be $1,050 per transaction regardless of how far down the stock travels. If BIDU heads up to 152.50 in 28 days, the spread probably would widen to about 13.00 for a profit of $2,500 per transaction. If BIDU rose to that price over a 47-day period of time, the spread would widen to 17.50 for a profit of $7,000 per transaction. The Dec 155 calls act as a stop against further profits should BIDU travel north of 155, however.
Changes in the price level of time value are not a problem using this spread strategy. The 6.00 of time value embedded in the 16.00 premium for the long 135 calls is counteracted by the 5.50 in time value in the short 155 calls. Another added benefit to using the spread strategy is the low cost ($1,050) to establish the position. Purchasing 100 shares would cost $14,500, half that amount if purchased on margin. If the underlying contract was a futures contract, similar leverage to options might be achieved; but if the trade went against you, you would need to shovel more money into the account.
If the underlying instrument (stock, future or ETF) is traded back and forth frequently on an intraday basis, using stop orders might be the best way to go. The biggest drawback would be when the stop order is triggered and then the underlying instrument immediately reverses course. The options strategy works best in that case, as well as when the trade goes against you.
If it’s a long-term position being traded, it seems clear that some type of options strategy works best, especially in the case of a large overnight move against you. The purchase of a call against a short position or put against a long position as an insurance policy has the problem of time decay that is inherent in options. That can be eliminated by using the outright spread strategy, which has the drawback of capping profits. All of these strategies have their pluses and minuses, but using none at all is the biggest minus of all.
Dan Keegan is an instructor with the Chicago School of Trading. Reach him at dan@thechicagoschooloftrading.com.
