Excerpts from an excellent post from Sean (the minimalist trader)
Breaking News: Markets are risky.
Ok, you knew that. You wouldn’t be here if you weren’t already permanently scarred by a bad beat at least once in your career.
Today, a new element of risk has been introduced via market structure. The May 6th flash crash was the first headline advertisement for what surely has become a topic on every active traders’ mind. Stories proliferated around that time of traders who got blown out on that day, and investors who’s way-out-of-the-money stops were triggered, only to watch their stocks swiftly rebound to a more normal price. And even to this day, it seems at least once a week some random stock has its own mini flash crash as a result of some computer gone haywire or a cascade of triggering stop orders.
Traders and Investors are rightly concerned about this, and some are downright scared. It puts many of us in awkward positions. We all know we should trade with stops firmly in place, but in this new marketplace it seems putting a resting stop order on the books is practically an invitation for some HFT [High Frequency Trading] stop-sniffing algo to hunt it down and force its execution. So do we then just put in mental stops? Seems like a logical jump, but that method is fraught with all kinds of its own headaches: What if I’m not at my desk when the trigger is hit? How do I exit? What if I’m frozen in a panic-stricken trance? It happens. Believe me.
For all these reasons and more, this is why I trade options and why I think options trading should become a bigger part of your trading arsenal.
Options trading has always been a useful tool to express a market opinion.
I utilize them because I can define risk. This is especially important when taking speculative, risky, or news-driven positions. This is simplicity in managing risk. And this is why I like options and feel that options are an essential tool for any Minimalist Trader.
Sean’s fears are very realistic. We’ve seen the system break down, and although I’m more confident than he about it the severity – the next time it happens, there is no way to be certain.
Just one more reason for using options.
Because options already provide a good hedge, option owners don’t have the need to enter stops. Yes, those stops are important for a stockholder whose 1,000 shares of a $50 stock can lose $25,000 in a heartbeat, but the call owner, who has 10 calls valued at $500 each, does not face the same problem. If there were a flash crash, it may be worth holding, rather than selling them via a market order during a panic. The IV surge that accompanies panic will boost the value of the options. If you do not want to bet on a reversal, it’s okay to sell – but please use a limit order.
Call and/or put owners already have limited loss. For most traders, that should be enough protection. If you trade deep ITM options, you are in the minority and must decide whether stops are worthwhile for you. Just be aware that option markets commonly have wide bid/ask spreads – and that’s more true in a panic situation. Thus, market orders tend to get distrous fills.
If you sell credit spreads, trade iron condors, sell naked options etc., then the market panic is going to hurt. One piece of good news is that loss is limited. Another is that when a big move is accompanied by a volatility surge, credit spreads do not get near the maximum value. If you decide to exit, rather than hold, the loss will be less than expected due to that pumped IV. [When both options of a credit spread move into the money, the position has positive vega]
Bottom line: Options provide the opportunity to trade with reduced loss. As does Sean, I urge investors to consider options and option spreads as investing vehicles of choice.