Options as stop orders

March 4, 2018 09:00 AM
Options

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On the evening of Nov. 8, 2016, most people thought that Hillary Clinton would win the presidential election. While not especially beloved by the voting public, Clinton was a familiar face. American voters tend to feel comfortable with familiar faces. Clinton’s opponent was the mercurial Donald Trump. While Trump was no doubt a familiar face, he certainly was not considered to be presidential timbre. 

When he first announced that he was running for president in August 2015, Trump was a 25:1 underdog. Prior to the first debate between Trump and Clinton, the odds had narrowed significantly to 6:4, with Trump still being the underdog. On election night, however, Clinton was the 5:1 favorite. It’s fair to say that the market had a Hillary Clinton presidency baked into the cake. However, something unexpected happened. 

Virginia was supposed to be an easy Clinton victory but instead was a narrow win for her. Florida and Ohio were called for Trump. Pennsylvania, Wisconsin and Michigan were considered Democratic locks, but when late in the evening Pennsylvania and Wisconsin went to Trump and Michigan was too close, all hell broke loose in the markets. The Dow futures, which had been up more than 100 points earlier in the evening reversed course and were down more than 800 points. The S&P 500 futures and the Nasdaq 100 futures were down 5% at one point, which was limit down.

As the night wore on and Trump gave a rational acceptance speech, the losses were paired. At the end of the trading day on Nov. 9, 2016, the Dow was up 257 points over the previous day’s close while the S&P 500 and the Nasdaq were each up 1.1%. 

A similar thing happened after the Brexit vote. The Dow fell 611 points (3.4%), the S&P 500 fell 3.6% and the Nasdaq was down 4.1%. Within two weeks, the market more than made up for those losses. 

One way to prevent losses in a deteriorating position is the use of stop-loss orders. A stop-loss order is activated when a stock, ETF or futures contract reaches a certain price point. Let’s use the example of Facebook (FB). On the afternoon of Jan. 4, 2018, a purchase of FB is made at $185. After rising above $188 a stop is placed to sell FB at $184 (just below the previous high close) on Jan. 11. This means that at $184 the stop becomes a market sell order and the long position is liquidated. 

Stop orders work best if you’re actively day trading. If you plan on carrying a position overnight or longer, their risk management is less attractive. The problem with stops is that in fast or thin markets the order can be filled at a significantly worse price. This is called slippage. You can avoid slippage with a stop-limit order, which requires the stop price to turn into a limit order rather than a market order or to be filled within a specific limit of slippage. Stop-limit orders are not as common as stop-loss orders because they can defeat the purpose of getting out of a bad position if the market does not touch the limit price again. 

After closing at $187.77 on Jan. 12, FB gapped lower by $9.71 to $178.06. That $184 stop was executed at $178.06 for a huge loss. 

A more effective method of risk management is the use of options. If you buy JP Morgan Chase at $113.16 the maximum possible loss is $113.16. You can enter a stop-loss order at $110. This means that when JPM trades at $110, your position will be liquidated at $110 or lower. Under normal circumstances, the price should be somewhere around $110. If you are carrying the position over a longer time period and there is an overnight gap to the downside, there is no telling where you might sell your stock. If you were to buy February 110 puts at 92¢ your maximum possible loss would be $4.08. Once JPM trades below $110, the amount made on your long puts cancels out any losses on your long stock. The breakeven point on your puts would be $109.08. You buy one put for every single futures contract or 100 shares of an ETF or stock. An option is a stop order with a premium attached to it. If you were to short five futures contracts you would buy five upside calls to “stop” any further losses. The problem with a traditional stop order is that you are smoked out of your position and if there is a quick snapback then you are out of luck.  

In our FB example, a 184 put could have been purchased for around $3 when FB set its all-time high of $188.90 on Jan. 8. Once the market gapped lower, the put would be in-the-money and the loss would be limited to the difference between the purchase price and the put ($1) and the cost of the put. Perhaps more importantly, if the market reversed back higher, a trader did not lose the opportunity to profit on the initial long position (see “Facing the gap,” above).  

Let’s go back to our initial examples from election night and Brexit. How many long equity positions were stopped out at huge losses in the initial overnight sell-off? That is a lot of opportunity lost. If traders holding long positions had protected themselves with options instead of stops, they could have slept well, and woke up much richer.   

When he first announced that he was running for president in August 2015, Trump was a 25:1 underdog. Prior to the first debate between Trump and Clinton, the odds had narrowed significantly to 6:4, with Trump still being the underdog. On election night, however, Clinton was the 5:1 favorite. It’s fair to say that the market had a Hillary Clinton presidency baked into the cake. However, something unexpected happened. 

Virginia was supposed to be an easy Clinton victory but instead was a narrow win for her. Florida and Ohio were called for Trump. Pennsylvania, Wisconsin and Michigan were considered Democratic locks, but when late in the evening Pennsylvania and Wisconsin went to Trump and Michigan was too close, all hell broke loose in the markets. The Dow futures, which had been up more than 100 points earlier in the evening reversed course and were down more than 800 points. The S&P 500 futures and the Nasdaq 100 futures were down 5% at one point, which was limit down.

As the night wore on and Trump gave a rational acceptance speech, the losses were paired. At the end of the trading day on Nov. 9, 2016, the Dow was up 257 points over the previous day’s close while the S&P 500 and the Nasdaq were each up 1.1%. 

A similar thing happened after the Brexit vote. The Dow fell 611 points (3.4%), the S&P 500 fell 3.6% and the Nasdaq was down 4.1%. Within two weeks, the market more than made up for those losses. 

One way to prevent losses in a deteriorating position is the use of stop-loss orders. A stop-loss order is activated when a stock, ETF or futures contract reaches a certain price point. Let’s use the example of Facebook (FB). On the afternoon of Jan. 4, 2018, a purchase of FB is made at $185. After rising above $188 a stop is placed to sell FB at $184 (just below the previous high close) on Jan. 11. This means that at $184 the stop becomes a market sell order and the long position is liquidated. 

Stop orders work best if you’re actively day trading. If you plan on carrying a position overnight or longer, their risk management is less attractive. The problem with stops is that in fast or thin markets the order can be filled at a significantly worse price. This is called slippage. You can avoid slippage with a stop-limit order, which requires the stop price to turn into a limit order rather than a market order or to be filled within a specific limit of slippage. Stop-limit orders are not as common as stop-loss orders because they can defeat the purpose of getting out of a bad position if the market does not touch the limit price again. 

After closing at $187.77 on Jan. 12, FB gapped lower by $9.71 to $178.06. That $184 stop was executed at $178.06 for a huge loss. 

A more effective method of risk management is the use of options. If you buy JP Morgan Chase at $113.16 the maximum possible loss is $113.16. You can enter a stop-loss order at $110. This means that when JPM trades at $110, your position will be liquidated at $110 or lower. Under normal circumstances, the price should be somewhere around $110. If you are carrying the position over a longer time period and there is an overnight gap to the downside, there is no telling where you might sell your stock. If you were to buy February 110 puts at 92¢ your maximum possible loss would be $4.08. Once JPM trades below $110, the amount made on your long puts cancels out any losses on your long stock. The breakeven point on your puts would be $109.08. You buy one put for every single futures contract or 100 shares of an ETF or stock. An option is a stop order with a premium attached to it. If you were to short five futures contracts you would buy five upside calls to “stop” any further losses. The problem with a traditional stop order is that you are smoked out of your position and if there is a quick snapback then you are out of luck.  

In our FB example, a 184 put could have been purchased for around $3 when FB set its all-time high of $188.90 on Jan. 8. Once the market gapped lower, the put would be in-the-money and the loss would be limited to the difference between the purchase price and the put ($1) and the cost of the put. Perhaps more importantly, if the market reversed back higher, a trader did not lose the opportunity to profit on the initial long position (see “Facing the gap,” above).  

Let’s go back to our initial examples from election night and Brexit. How many long equity positions were stopped out at huge losses in the initial overnight sell-off? That is a lot of opportunity lost. If traders holding long positions had protected themselves with options instead of stops, they could have slept well, and woke up much richer.   

About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.