Options: An Alternative To Stop Orders

You need two important skills to become a successful trader. First is the ability to pick the right markets. The second is the ability to think on your feet when the market turns against you and knowing when to exit a position.

While many trading techniques and strategies teach these skills, conventional trading wisdom insists the proper way to protect yourself from losses is to use a stop order. While stops are useful, there are inherent problems that can be overcome by using options as an alternative. When you compare stops and options side by side, options have properties that are clearly favorable for those looking to protect a position. Let's see how the use of stops and options stand up in fast-moving markets.

Disadvantages of Stop Losses

Once the price of a security surpasses a 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 for a loss.

Unfortunately, a stop order is somewhat like the emergency brake in your car. While it does 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.

Several market scenarios expose the inherent flaws of stops and their inability to protect you from unexpected losses. Whether it's fast-moving markets, consolidating markets, or fundamental shifts in supply and demand, stops force traders to jump ship. This is a one-size-fits-all solution that's better handled by using options to ease out of the position, shift market time frames or reverse the position.

Options As an Alternative

When you use a stop-loss order in a fast-moving market, there is no guarantee that you will receive your stop price. Since the stop is a reactionary tool designed to get you out of the market immediately when you are losing money, there is a good chance the fill price will be worse than the price you set in the order. This is known as slippage.

For example, if you go long gold futures at $1280 and set your stop at $1270, hoping to limit a loss to $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 until $1265, generating a $1500 loss, or 50% more than you had anticipated.

On the other hand, if you use an option with a strike price of $1270 instead of a stop in the same market, you can't lose more than the strike price. 

Advantages of Using Options

Of course, you have to pay for the option's premium, but two things can work in your favor. First, out-of-the-money options typically cost less than in-the-money options. Also, options that gain value when there is an opposite move to the current market's trend 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 is the easiest way to directly control slippage while managing loss.

One example is the use of a protective put. A put option gives the holder the right to sell the underlying asset at a predetermined strike price, and so the protective put sets a known floor price below which the investor will not continue to lose any added money even as the underlying asset's price continues to fall.

Consolidating markets are a second market condition where stops can work poorly. It is rare for any market to move straight up or down. Unfortunately, you never know if the counter-trend is simply a consolidation or a trend change. Since stops can't differentiate between alternatives, you are forced out and have no stake if the market was simply consolidating and resumes movement in the direction of your original position. This is known as the whipsaw effect.

Stops are an all-or-nothing proposition, leaving little room for consolidation and retracement behavior. So you could be right about the market but stuck on the sidelines because the stop was placed at the wrong price or at the wrong time. However, if you place an option where you would have placed your stop, you can hold onto a losing position for a longer period while determining if the market is consolidating or changing trend.

By having an option in place of a stop during fundamental shifts in the market, you can diminish the impact in two ways. First, you insulate yourself from moves that aggressively erode your position because the option is gaining at the same pace. Second, if the shift doesn't generate a big move but does signal a trend change, you can leg out of the position without chasing the market. 

The Bottom Line

Options present a clear alternative to using stops to manage losses. To succeed at this strategy, look at trading in the same way as money managers. Money managers recognize the interdependence of underlying assets and options contracts and a built-in risk management relationship that can diminish losses. Through this approach, they use finesse and control to protect themselves from fast-moving markets, consolidating markets and fundamental shifts in supply and demand.