To become a successful trader you need to have two important skills: the ability to pick the right markets and the ability to think on your feet if/when the market turns on you. While there are many techniques and strategies that are designed to help you develop the ability to make these investment decisions, conventional trading wisdom has always insisted that the proper way to protect yourself from losses is to use a stop. While stops are sound in theory, there are several inherent problems, but these can be overcome by using options to limit your losses instead.
Disadvantage of Using Stop Losses
Once the price of a stock surpasses the predefined entry/exit point, the stop order becomes a market order. On the face of it, a stop order looks like a great tool. You pick a trade, and if the market moves against you, your stop is triggered and you are kicked out of the trade.
Unfortunately, a stop is much like the emergency brake in your car. While the emergency brake can do the job, there is little finesse or control in how and when the car stops. In other words, when a stop is triggered and it becomes a market order, almost anything can happen.
Three situations consistently occur in trading that expose the inherent flaws of stops and their inability to really protect you from loss when you need them the most. Whether it's fast-moving markets, consolidating markets or fundamental shifts in supply and demand, stops pigeonhole traders to jump shop! This is an unnecessary one-size-fits-all solution, which could be better handled by using options to ease out of positions, shift market time frames or reverse your market position without exposing yourself to more risk than if you had used a stop by itself.
An Alternative Solution
When you compare stops and options side by side, options have some properties that are clearly favorable for those looking to protect a position. Let's look at how the use of stops and options stand up to fast-moving markets.
When you use a stop-loss order in a fast-moving market, there is no guarantee that you will receive the price at which you set your stop. In fact, because stops are a reactionary tool designed to get you out of the market immediately when you are losing money, there is a good chance that the price at which your trade will be filled will be worse than the price you set in the order. This is known as slippage.
For example, if you go long a gold futures contract at $880 and set your stop at $870, you would hope that you have locked in a guaranteed loss of no more than $1,000 ($1 decline in contract price = $100 loss). However, if your stop is triggered in a fast-moving market, it turns into a market order and you may not exit the market until $865, creating a total loss of $1,500 and losing 50% more than you had anticipated.
Advantages of Using Options
Of course, you have to pay for the option, but two things work in your favor. First, out-of-the-money options typically cost less than in-the-money options. Also, options that are in the opposite direction of the current market's movement tend to have less volatility, which tends to make them less expensive. The use of an option in this way is known as a hard stop and it is the easiest way to directly control slippage while managing loss.
Consolidating markets are the second market type that stops have a problem navigating. It is quite rare for any market to move straight up or straight down. Along the way, the market will pull back. Unfortunately, you never know if the pullback is simply a market that is consolidating or if there is a fundamental shift in the market's direction. Since stops treat both situations the same, when a stop is triggered, you are forced out of the market. You can do little if the market was simply consolidating and halts the move against you and begins to move in the direction of your original position. This is known as the whipsaw effect.
Because stops are an all-or-nothing proposition, they leave little room for the market's constant consolidating and retracement behavior. This has the effect of you potentially being right about the market, but being stuck on the sidelines because you were stopped out. A well-placed option can have the opposite effect. If you place an option where you would have placed your stop, you will be able to hold on to a losing futures position slightly longer. Even if the Delta of the option is different from the underlying futures, as you lose money on the futures position, the option helps offset some, if not all, of your losses as it increases in value. This gives you the necessary breathing room to determine whether the market is consolidating or changing.
By having an option in place of a stop during fundamental shifts in the market, you will be able to diminish the impact in two ways. First, you insulate yourself from moves that aggressively erode your futures position, because the option is gaining at the same pace. Second, if the shift is not drastic enough to cause a limit move, but it does signify that the market is no longer moving in the direction of your original position, you can "leg out" of your position without chasing the market. You exit the losing futures position and hold on to the winning options position, with little need to incur any more commission expenses than necessary.
The Bottom Line
Over the years, the difficulty of using stops alone has been recognized. However, options present a clear alternative to using stops to manage losses. In order to succeed at this strategy, however, you must look at trading in the same way that money managers do. Money managers look at the interdependence of futures and options contracts and the built-in risk management relationship that they have with one another to diminish their losses. By taking this approach, they are able to use finesse and control to protect themselves from fast-moving markets, consolidating markets and fundamental shifts in supply and demand.