This Common Tactic May Not Be The Best Way To Manage Risk With Options…

Some of the most common questions we get from traders who begin trading options are about managing risk.

For example, let’s say you begin selling put options. After making a series of trades, you begin to think about ways to better manage risk. Naturally, one of the first thoughts you may have is to wonder whether it makes sense to use stop-loss orders to exit a position if the trade moves against you.

With this in mind, let’s analyze some strategies for managing risk. We’ll also explain why it may not be a good idea to use traditional stop orders for option positions.

The Basics

If you’re not familiar with the put selling strategy, let’s do a quick overview:

— A put option gives the buyer of the contract the right (but not the obligation) to sell 100 shares of the underlying stock to the put seller. This is agreed to at a pre-defined price, called the strike price.

— When selling puts, you take on the obligation to buy the stock at the strike price if the stock drops below that level before the option expires. The income you receive for taking on this obligation is known as premium.

— The price of a put option rises when the underlying stock declines, and declines as the underlying stock rises. A put option also loses value as it approaches expiration (which benefits the put seller).

— The strategy we most often recommend involves selling puts on stocks that we would be willing to purchase at that lower price. If the stock remains above the strike price, we simply keep the premium as profit. If the stock trades below the strike price, we become obligated to purchase it at a discount.

When selling puts, income is generated when the underlying stock remains stable or trades higher. The put option loses value for the seller when the underlying stock trades lower. This is because a put option rises in value as stocks drop. And since we are “short” the put (that we have sold to create income), the more the put option rises in value, the greater our loss.

Potential Roadblocks

Many traders may think about using a stop-loss order when selling puts. Because they are short, it would be known as a buy-stop order. This automatically buys back (or “covers”) the put option if the price rises to an unacceptable level. For instance, let’s say we sell a put option at $2.50 and set a buy-stop order at $4.50. We would automatically buy back our put option if the price hit $4.50, incurring a $2 loss per share.

While this approach sounds like a responsible way to manage risk, there are two big problems with it:

1. Options do not trade like stocks.

Most investment-grade stocks trade in a liquid manner, with shares changing hands throughout the entire trading day. In a typical day, a stock may move from $51 to $53, for example. It would hit most of the price points in between. Sure, the stock may skip a few cents, but under normal circumstances, it would not jump more than that without an actual “printed” trade.

Option contracts, on the other hand, are notorious for gapping higher or lower. Although there is an “available” market for these contracts, the contracts may not actually print a transaction. (Usually there are market makers on both the bid and the ask side of the trade.)

This creates a significant amount of risk for us if we use stop-loss orders. In some instances, the option price could move significantly higher before a new trade is executed. By the time our stop-loss order was executed, we could be hit with a very unfavorable exit price.

2. Market makers can take advantage of stop-loss orders.

Some on Wall Street refer to market makers as swindlers and thieves. But we actually need the function they provide, particularly in the options market. And while they may not be out to steal your money, it is true that they operate with profit in mind. And they can make profits off your stop orders.

For instance, let’s say an option market maker knows that there are a number of buy-stop orders in play if a put option hits $4.50. That market maker could actually execute a trade at $4.50 simply to get the stop orders to trigger. He would then sell his inventory to fill the stop orders, sending the price back to a lower level.

There are a number of games that market makers can play in the relatively illiquid options market. And while we’ll stop short of accusing these traders of market manipulation, it’s worth noting that stop-loss orders in general do not fare well for option trades.

A Better Way…

Rather than use an actual stop-loss order for your option positions, we recommend setting an alert for the underlying stock. This is because stocks trade with much more frequency and predictability than options. And we can glean more useful information from the price action of equities.

For traders selling puts, the best solution would be to note the level at which a stock decline would cause you to want to exit your position.

Let’s say you have sold a put option on a stock and you would be concerned with a drop below $20. One way to manage your risk would be to set an alert for the stock at $19.95. If triggered, you would then buy to cover your puts. This avoids the issue of having an option contract gap through your stop price. It also keeps your order out of the hands of market makers.

Another option would be to actually have a sell-short order in place for the underlying stock. So you would be selling short shares of the stock if the price hits $19.95. This would offset your obligation for the put contracts that you are short. This is because while you will still be obligated to buy shares at the strike price, that purchase will naturally offset your short stock exposure.

There are many ways to manage your risk when using option strategies. This is just one of them. The key is to make sure that you are not exposing yourself to other unintended risks through the process of managing your initial trade.

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