Options Trading

Creating Stop Orders for Options Trades

At Wanderer we preach the need for using stops on trades. Without knowing your risk you can't accurately calculate your reward-to-risk, and without that it's impossible to determine if a trade is worth entering in the first place.

This is simple and easy to do with stock trades, but options are another beast, and unfortunately it's not quite so straightforward with them. But that doesn't mean you can't protect your downside risk with options.

Why Not Use a Typical Stop Order?

"Our brokerages offer sell stop orders on the options order entry screen, so why not use it?"

Two reasons: Bid/Ask Spreads and Volume

Before making an option trade the first thing we look at in the option chain is the Bid/Ask spread. What is the price we could immediately buy and sell at? Generally the price we can receive is somewhere in the middle of the Bid and the Ask. When making a new trade I recommend not trading unless the option spread is under 5%.

For example, if the current bid is $5.00 and the current ask is $5.20, you've got a roughly 4% bid/ask spread ($5.20 - $5.00 = $.20, and $.20 / $5.10 mid-price = 3.9%). You can typically buy or sell somewhere in the middle of the two.

Options don't usually trade high volume (they are leveraged instruments after all). This isn't necessarily a big deal for retail traders, as there is a market maker on the other side who will provide the liquidity to get a trade executed. In the example above, if you were to place a limit order to sell 10 contracts at the bid price of $5.00 you could reasonably assume you would get filled.

However, there is no guarantee that the bid size is actually ten contracts at the moment you place the trade. With your limit order you might be filled there, even if there were originally only a couple contracts being bid for at that price. It's likely another market participant (or the market maker) would see the remaining contracts for sale and would buy them. But what if the order had been a stop order instead?

In that case you may have gotten one or two contracts sold at $5.00, but the next actual sitting order might not be until $4.80, and that might only be two contracts, and then $4.60 for two more, etc.. You can see how a stop market order could quickly blast through the small amount of standing buy orders.

So why not use a stop limit order so that the worst you can do is get $5.00? Well, because that provides a false sense of security. It's okay to do if there is no alternative (maybe you are going to be out of internet range for a while), but it leaves wide open the possibility that you don't get filled at all. If the stock price were falling quickly the option may blow right past your stop limit.

Calculating the Stop

Another important factor to consider is that we choose a stop based on a stock's price level on a chart. For example, we may have our stop directly underneath an old high and the 50-Day Moving Average. That would be a strong support level, and we'd want our stop to be just below that. However, calculating the price of an option right at that level is an inexact science. We can calculate where we think the option price will be, but it could vary by a few percentage points. That, in turn, could cause us to stop out of our option trade just ABOVE support instead of below it. If that support then does its job and the stock rallies again, you'll have been stopped out of your option for no reason.

So How Do You Protect an Option Trade?

The best thing to do with options trades is monitor them closely. If you know you won't be able to do that, then you should consider if it is a good idea to make the trade in the first place.

Instead of an option stop order, you should set an alert on your chart of the stock. This is very easy to do in TradingView. I set an alert at a price slightly above my stop price, along with a short note saying to close my calls. When I receive the alert, I can very quickly bring up the chart to monitor, as well as prepare a sell order for the options. If my stop price is then triggered I can very quickly hit send on my order.

Click the Alert button at the top of the chart. Set a Value for the stock price slightly above where you'd like the stop price to be. Add a note. Click Create.
Click the Alert button at the top of the chart. Set a Value for the stock price slightly above where you'd like the stop price to be. Add a note. Click Create.

Trading options, because they are leveraged instruments, means you need to take exceptional care of your positions. They require your attention. If there is no other choice, use a stop order, but you should try your best to monitor these positions closely. Setting a simple alert on the stock's chart above your stop price will give you the heads up you need to make sure you manage your risk appropriately while still being sure to give the trade the room it needs to work.