Trading Options Using Stop Loss Orders

I have been asked several times about my thoughts on using stop-loss orders when trading options.  The main thought I have on this topic is that options are not stocks and must be traded differently.

When a stock moves through a certain price level, it's appropriate to use a stop-loss.  Why?  Because the price may represent the maximum you are willing to lose on the trade, and limiting your losses is intelligent.  Or perhaps the stock has broken a support level – something that's important to traders who use technical analysis.  The stock price is the stock price and if it hits your target, getting out of the trade can be a wise decision.  Or perhaps the stock has moved to your target and you want to take those profits.  This is technically a stop-gain order, but all you do in this case is enter a limit order to sell.

But, options are different.  There are many factors that go into the pricing of an option and you may be stopped out of the trade because of something totally irrelevant (and temporary) to the reason you bought (or sold) a specific option.  If IV gets crushed and you own options, your stop-loss point could easily be triggered, even if the stock is performing to your satisfaction.

If you sold an option, a stop-loss is prudent, but again, a sudden spike in implied volatility can push the option price through your limit – when you would prefer to hold.

Using stops on options is a difficult business.  Especially when bid/ask differentials are wide.  Would your stop order be triggered by the last trade, the option's bid, the option's offer?  Something else?  You must ask your broker what methods are used.  It's crucial.

If you feel you must use stop-loss orders, place the stop on the price of the underlying stock, and not the option.  When triggered, the option position will be closed 'at the market.'  That's not good, but it's a bit better than using a stop-loss on the option itself.


Spreads

It's much worse with spreads, and I recommend that you avoid using stop-loss orders, unless you have a complete understanding of how your broker decides when the stop-loss price is triggered and how they go about entering orders to exit the trade.  My guess is that the broker will kill you.  Intentionally.  Why?  Because they will not take responsibility for entering a limit order and risk missing the trade.  Thus, they are sure to pay offers to buy in your shorts and sell bids to close out your longs.  That is a disaster and the losses resulting from the inappropriate handling of your position are often larger than the loss resulting from holding the position longer.  If you must use a stop loss, at least enter it as a spread order with a limit price.

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