Question:
Should I use an option to insure a
position against a loss as opposed to a stop loss?
Answer:
The greatest benefit of using options
instead of stop loss orders is that an option will allow you to “ride” a
market that is trading wildly. For instance, the large ranges that can be
encountered in the meat markets make it difficult to place good stop loss
orders without being stopped out prematurely. You might have chosen the
correct market direction, but the large swings the market makes can take
you out before you can realize a profit.
In an instance like this you might be
better off using an option that takes a position opposite your futures
contract as stop loss protection. However there are many more variables to
be considered when using an option as a stop loss making it more
complicated than simply using a stop loss order.
One problem with using options as stops is
liquidity. Since options normally expire about a month before the futures
contract comes due, you might not be able to trade the more liquid front
month contract if the options have already expired. This means you will
need to consider a further out contract that would still have options
available. It is possible to combine options and futures of different
months; however this strategy, known as spread trading, is not quite the
same as using options as stop losses.
By trading a further out contract you
could be trading a less liquid market while paying more of a time premium
for your option as well. This makes it important to consider the intended
length of your trade. If your trade is only for a short term (ie. days to
weeks) you might be better served by a stop loss order; however if your
time frame is one of several weeks to a month or more, an option would
allow you to ride the market swings without having to worry too much about
stop loss placement.
Choosing the correct option as a stop loss
is also a bit of an art and should be done in consultation with a competent
broker. Ideally the options whose strike prices are trading closest to the
money offer the greatest protection as they appreciate fastest if the
market moves against you. Unfortunately these options are also the most
expensive, so much so that even if you risk only a portion of the option
premium in the trade, you might be putting more money at risk than if you
used a large stop loss. Using an option with a strike price that is further
out of the money might be cheaper, but it will also appreciate less
quickly, thereby inflicting losses on your trading account until the market
reaches the option’s strike price.
Remember, the purpose of any stop, whether
it is a stop loss order or an option, is to take you out of a trade that is
not going as you had planned. By using an option, many traders might be
inclined to hold on to a losing position too long, instead of exiting and
looking for other opportunities elsewhere. This is why it is important to
have a trading plan, one that outlines where you expect the market to go,
and more importantly, how far you will allow the market to move against you
before you exit your position, whether you decide to use stop loss orders
or options.
There are several excellent trading
strategies that combine the use of futures and options; however for stop
loss purposes, depending on the market you are trading and the time frame
of your trade, you might find that a regular stop loss order is easier to
implement, cheaper, and easier to manage than using options.
-Erich
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Using Options as a Stop Loss
