I’ve been receiving some good questions from readers lately.
So, in today’s essay, I want to answer a common question about stop losses I often get asked…
Should I have stop (loss) orders on all of my options trades? How long should I wait after getting into a trade before I put a stop (loss) order on it?
– Brian
That’s a great question, Brian. Stop orders are designed to protect a profit or limit a loss. When trading stocks, it’s important to use stop orders to limit your downside risk so that one bad trade doesn’t blow up your account.
But when buying speculative call and put options, it’s different. You see, the most you can lose when buying an option is the premium you spend on it. So, your potential loss is already limited to a small fraction of the stock price.
As long as you exercise proper position sizing and don’t take on an option trade that is far larger than appropriate for your account, then you don’t need a stop-loss strategy when buying options.
Yes… you do need to be willing to lose 100% of the premium you spend on puts and calls. But losing 100% of a $1 or $2 option premium is far better than losing 10% or 20% of a $50 stock.
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But once an option trade is profitable, it makes sense to set a stop-loss price. As a trader, the worst feeling I get is when I’m watching a profitable trade turn into a loser. Don’t let that happen.
As a general rule, once an option position is up 50% or so, I’ll set a stop at my breakeven price. Then I’ll keep raising the stop as the trade continues to move in my favor. This way, I’m ensuring a profitable trade.
Finally, I almost NEVER enter stop-loss orders – on stocks or options – with my broker.
There’s just too much potential for “monkey business” if an options market maker looks at a quote screen and sees thousands of option contracts (from my subscribers) with stop-loss orders at the same price, and within range of being hit.
It’s better to keep your stop-loss as a mental note. Watch the position. And if the price hits your stop, then enter an order to exit the trade.
Of course, if you can’t constantly watch the position during the trading day, then your only alternative may be to enter your stop order with your broker. Or set your stop based on a closing price. Then you can exit the next day.
Best regards and good trading,
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Jeff Clark
Reader Mailbag
Do you set a stop-loss as a mental note, or do you go through your broker?
Let us know your thoughts – and any questions you have – at [email protected].