Risk Protection With Put Options and Stop Loss Orders
Most professional traders employ some form of downside protection to hedge their position against loss, caused by their long position turning against them and moving beyond expected trading range .
The biggest issue in this situation is figuring how much downside protection should be in place given the risk and the potential return on the trade.
In my own trading, I found that sometimes put options work best and other times, put options appear like a great solution, but from a practical perspective, the position doesn’t make sense because the option may have low liquidity, the spread may be too wide or the option that fits your financial requirements just doesn’t give you enough risk protection or time value.
There are two instances when put options work better and offer better protection against downside movement than stop orders. The first situation is when a price gap occurs to the downside. In this case, the trader utilizing a stop loss order would receive a price fill that’s substantially lower than the intended fill price, since the gap opened below the stop loss level, causing the risk on the trade to increase by the amount the stock opened below the intended price level.
To give you a practical example, assume you purchased ABC stock at $100.00 per share and you placed a stop loss order at $90.00. Assuming a few days after you place your stop loss, the stock opens at $80.00 per share, because the stock’s earnings are much lower than expected and the stock gaps down $20.00 at the open.
In this case, your sell stop would trigger and you would be filled at $80.00, instead of $90.00, thereby increasing your risk by 100% on the trade. One possible way to avoid this scenario is to use stop limit orders, and choose a limit price that’s a few points below your stop loss order.
Getting back to our example, let’s assume you placed the stop loss order at $90.00 and a limit level on the trade at $85.00 But in that case, you could end up in a worse situation, because instead of getting filled at $80.00, the opening price the next day, your order would simply NOT get triggered because the opening was $5.00 below your limit price, and you would end up holding the position and risking more risk to the downside, unless the stock at some point during the session rallied back up to the $85.00 level, which may or may not happen.
As you can see, neither of the two stop loss examples offer a feasible solution to adequately protect your position against gaps to the downside.
An ordinary stop loss will increase your risk and consequently your loss level, beyond the level you originally intended and if you use a stop limit order and the gap opens below your limit price, the trade will not get executed and unless you are monitoring the stock in real time, you may end up increasing your downside risk well beyond the intended risk level on the trade.
The other situation and one I particularly dislike, occurs when the stock moves lower to trigger the stop price level and then rebounds and rallies back up and trades higher once again. This situation can be extremely frustrating, because even though you picked the right direction and the stock rallied eventually, you did not participate in the move because you were stopped out prematurely.
Unfortunately, there’s no way to avoid these two scenarios when applying stop loss orders to your trades for protection.
In some situations however, using a stop loss order may end up being a better choice. If for example you are day trading and do not incur overnight risk, the odds of a major gap occurring during the trading session is rather slim, especially if you are trading assets that have reasonable levels of liquidity.
Another scenario when using stop loss orders may be a better fit than put options, is when the trader is utilizing a long term investment or trend following approach to the markets. In these situations, there’s no way to ascertain how much time the trade will be held, and ultimately buying put options continuously may prove to be a very expensive proposition, especially if the asset is intended for long term capital appreciation.
In my personal trading, I find that put options work best when my holding period is limited to no more than a few months. This allows me to buy an out of the money put option that has enough time value to offer me adequate protection, without the high cost that comes with buying an option that’s at the money. It’s a great trade off between risk and reward and the majority of the time, I end up liquidating the option before it expires and partly recouping some of cost that was originally paid for the option.
In conclusion, whether you buy a put option or utilize a stop loss order is best determined by your intended holding period, the volatility or trading range of the underlying asset and whether the underlying asset that your holding is prone to price gaps. You have to take these factors into account and consider the upside and the downside of each before deciding whether to use stop loss orders or put options.