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Using Options as a Stop Loss? - 11-9-2003

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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