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How to: Set stop losses on Options as you would a Stock Trade


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How to: Set stop losses on Options as you would a Stock Trade

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  #1 (permalink)
Chicago, Illinois
 
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I will give an example using a MSFT. It is a stock I am interested in (although I will not be trading it because of the high IV at the moment.

Step 1: Figure out where you want your stop to be:
Here is the Weekly Chart of MSFT:

Current price: $39.21
Where I would place my stop if it was a stock: $38
Difference between the two: $1.21

Step 2: Find out what option you want and what the delta is
This is where you use Technical Analysis, Fundamental Analysis, or whatever strike price tickles your fancy. Personally, a price that I think is feasible in the long term for MSFT is $45 so let's take a look at the Jan 2015 $45's:

The two far left columns shows the delta. Currently the $45 Call has a delta of 0.23. That means that ( if all things remain the same) if MSFT stock fell $1.00, my calls would only fall $0.23.

Step 3: Multiply your Delta by the size of your stop loss
With the delta, one interesting but often overlooked is that the delta can also be used as a percentage.. if you make 0.23 out of 1.00 then the option tracks the stock @ 23%.

Our initial stop loss of $1.21 is based off of a stock purchase which is 100% efficient...ie if the stock moves up a penny, we get a penny for each share we own. However, since we now know that the option that we choose only tracks stock price movement @ 23%, we want to make sure that our stop loss is approximately 23% of the $1.21. To figure this out, we multiply the two numbers together:

0.23 x $1.21 = $0.2783.

Because the delta is so small, your option position is the equivalent of buying the stock if the price was only $0.27 away from the current price levels. (This is 23% of the stock stop loss that was $1.21). What this means is that if MSFT stock price falls $1.21 to $38, I expect the $45 January 2015 Call options to fall $0.27. Since the current option spread is $0.91 x 0.97, I would expect the spread to be around .64 x .70 if MSFT went down to $38

Step 4: Know how much you want to lose
Before I enter a trade, I always have a number in my head that I am willing to lose before I exit the trade. Before commission, I prefer to lose no more than $180 on any given trade.

Step 5: Divide the amount you want to lose in the trade by your new option stop loss
We determined the option stop loss was $0.27 in Step 3. In Step 4 we determined that I never like to lose more than $180 on a given trade.

$180/27 = 6.67 contracts. (remember that $0.27 for an option contract is actually $27, not literally $0.27) Based on the current delta prices and my stop loss amount, I can buy approximately 6 contracts.

Notes
If there is a small amount of time left in on your options, or there is a very big move lower in Implied Volatility, then the stop that you created will be irrelevant. Personally, I buy LEAPs (aka options that have a lot of time left on them) so that time decay is pretty much imperceptible but at the least, I would recommend that traders start out with options that have at least 2-3 months until expiration. After that, you can decide whether short term options are right for you or if you prefer medium-to-long term options. Short term options are by far the most volatile type of options and require a lot of attention.

I also ideally look to buy options that have low Implied Volatility as well (which is why I am not personally entering MSFT even though I like the chart). The thing to remember about Implied Volatility is that if you buy when Implied Volatility is high, you can guess right and still lose money. On the flipside though, the reverse is true for low implied volatility... you can be wrong about your direction, but because people push the price up in fear, your calls can still increase in value and/or maintain their value which allows you to exit while saving more money than if you used stock. Depending on your objectives however, a high IV can be a good thing. A lot of spread traders seek out that kind of environment. Personally though, I am looking for multi-baggers, and the downside of vertical spreads is that they put a cap on profitability. I am all for risking $1 to gain $3, but I like to keep the option open so that the $1 I risked can turn into $15 if there is a big move.

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  #3 (permalink)
Colorado Springs, CO, USA
 
 
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TD Ameritrade, using their TOS platform, lets you place orders that trigger on the price of the underlying. So, for your example, you could just place the closing order to close when the last price of MSFT is below $38. No calculations necessary.

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  #4 (permalink)
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rrvb View Post
TD Ameritrade, using their TOS platform, lets you place orders that trigger on the price of the underlying. So, for your example, you could just place the closing order to close when the last price of MSFT is below $38. No calculations necessary.

Similarly, IB's TWS will trigger hitting the bid , offer, midpoint etc based on underlying hitting a price or other criteria

Market makers determine the prices offered, hence why I use the above example for those times I trade options. Market makers care little for what option prices "should be" priced at, and just focus on taking your money.

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  #5 (permalink)
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rrvb View Post
TD Ameritrade, using their TOS platform, lets you place orders that trigger on the price of the underlying. So, for your example, you could just place the closing order to close when the last price of MSFT is below $38. No calculations necessary.

Where are the instructions on TOS for setting Options stop loss based upon the underlying? Thank you.

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  #6 (permalink)
Colorado Springs, CO, USA
 
 
Posts: 12 since Apr 2014
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Here's a video that shows how to place an option order that's contingent on the underlying stock price:


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