How To Use Option Stops in Option Strategy

Like Stock Trading, Option Trading involves risks and rewards and it is in every trader’s interest to limit the risks involved and increase the rewards. One way of conveniently allowing a trader to limit his risk and keep the small profits to keep on accumulating when a stock is moving in a trader’s favored direction is through the use of Stops. In this case, since we are dealing with Options, they are called Option Stops.

Option Stops Defined

Options stops are a risk-management tool used by investors to setup a threshold in which an automatic Option Trade is triggered when the price of the underlying asset reaches or falls / exceeds the set threshold.

Buying and Selling of Options

In the previous article, we discussed how the buyer of an Option can subsequently sell the same Option before the expiration date and how the seller of an Option can subsequently buy the same Option before the expiration date. This means that the buying and selling of Options before the expiration date, when done wisely, can in already produce a profit!

For example, let us say that Mr. Bob, an Option Trader, expects that after a month the price of General Motors will substantially rise from the current market of $55. So he buys a Call Option to allow him to buy 100 stocks of General Motors for $57 within a month for a premium of $300.

Now let us assume that after a week, the price of General Motors has risen to $62. At that time, the Option became more valuable after the market price of General Motors rose to $62 because the Option Holder has the right to buy the shares of General motors at a cheaper price of $57. The Option was now valued at $600.  At this point, if Mr. Bob exercises the Option, he will profit $200 (62 – 57 = 5; 5 x 100 = 500; 500-300=200). However, if he sells the Option instead, he can profit as much as $300 (600-300).  Hence, in this case, Mr. Bob can profit more from selling the Option rather than from exercising it.

This time, let us assume that instead of $62, the price actually falls to $50. When this happens, the intrinsic value of the Option is zero and value of the Option becomes equal to the time value.  At this point, let us say that the value of the of Option falls to $100. There is no point in exercising the Option since the strike price is higher than market price. However, the holder of the Option can sell the Option for $100 which will reduce his potential loss at this point from $300 to $200. If the price continues to fall and never reaches $57 when the expiration date arrives, Mr. Bob would have lost the premium he paid. In this case, selling the Option limits Mr Bob’s potential losses.

Importance of Stops in Option Trading

Stops serve as an activation point at which to execute a trade when the tide turns against a trader’s favor. Stops may be used to limit a trader’s losses short and let his profit build up.

In the example mentioned above, Mr Bob can set a Stop Order when the price of General Motors falls down below $45 because Mr Bob thinks that when the price falls down to that level, it will be almost improbable for the price to reach $57 before the Option expires. This means that when the price of General Motors falls to $45 or lower, the system will automatically send a market order to sell the Option, thus allowing Mr Bob to cut his losses short.

Types of Stops

Stop Order – a type of stop that will trigger a trade once the market price lands on or beyond/below the a fixed Stop Price. For example, if you set a stop price to be on or below $45, the system will automatically send a market order once the market price falls equal or below the stop price.

Time Stop – a type of stop that will trigger a trade after the expiration of a period of time. For example, if Mr Bob has set a Time Stop at 120 hours (5 days), the system will automatically send a market order after 120 hours regardless of the market price. Time Stops are especially important for Option Traders since Options expire after a period of time.

Trailing Stop –  a type of stop that will dynamically rise or fall on a trader’s favorable direction together with the market price. For example, if Mr Bob sets a Trailing Stop at $2 below the market price when market price of the stock was $55, the Trailing Stop will be $53. Then if the market price rises to $62, the Trailing Stop will change accordingly and rise to $60. If the market price falls to $61, the Trailing Stop will remain the same, $60. However, if the market price falls to $58 which is below the Trailing Stop of $60, the system automatically sends a market order to sell the Call Option. Trailing Stops are highly useful in cutting losses short and building up profit.

How to Use Stops Wisely

There really is no hard and fast rule to determine where to place your stop. It will always depend on the  risk-reward proportion that you are willing to take. However, it will be advisable if you use wide stops (stops that are far from the market price) if the market price is too volatile and use tight stops (stops that near the market price) if changes in the market price are not too drastic.

Furthermore, remember that the Stop Price you set is not necessarily the price that you will receive from selling your Call Option or the price that you will pay from buying back a Put Option.