Stop Loss and Options Trading/Investing

Many people want to learn about a Stop Loss and Options trading or Investing, and/or using some type of Trailing Stop with their Options positions.

I'd first like to mention that I don't trade nor invest in Options often at all.

I would though, be glad to provide what I do know from my experience with Options trading albeit minimal. I hope you'll be able to take something out of my experience to help you in the future.

At the bottom of this article, I have included a link to a friends website who has much more experience than I on this topic, so be sure to check out his information as well.

Here's what typically happens, and has happened to me as well: "I trade options, but I have been taking a beating because I have not been using any type of stop losses or trailing stops".

This is a common dilemma I believe, at least the question that arises from significant losses. One thing you may try, to get a better concept of what is happening here, is to use a stock trade as an example:

Let's say you have a trading strategy that uses $5,000 per stock position and that you use a $500.00, or 10% Stop Loss, or Trailing Stop Loss. In this example, you enter each stock position willing to risk $500.00, 10% of your money invested in the position.

Now, let's use an Options position using the same base example:

Most people who start trading Options will use the same $5,000 per position. Then, when the Option expires worthless, they have lost the entire $5,000. Since Options use Leverage on the stock or ETF they represent, think about using a much smaller amount per position.

For example, if you were willing to risk $500.00 in each stock position, consider using $500.00 total, for an Options position. This way you only have the same $500.00 at risk as with each stock position.

If you can get yourself to use a mental 50% stop loss for your Options positions, then try using $1,000.00 for each Options position and see how that goes. Just remember that Options prices can move large amounts in any single day, so any stop loss you use may not be the actual price you are able to get out at.

Using these smaller amounts for your Options positions will help you stay "in the game" longer and hopefully allow you to figure out a consistent strategy prior to increasing your position size.

Here's another concern that comes up: "When setting up trailing stops on options, do I set it up based on the stock price or the option price and what is a good percent to set them on."

I would say that because of the effects of Time Decay in Options pricing, I would want to have a maximum "Pain", or "amount willing to lose" or "at risk", set before entering any Options trade for sure. In fact, this should be done whether entering an Options or Stock position.

Using the example above, using $500.00 for an Options position would let you know the maximum you could lose, or if you used $1,000.00 as in the example above with a 50% mental Stop Loss, you would also have around $500.00 for your maximum loss.

The second part of the concern, is a reference using a "percent" stop loss on the Option Price. Since Options pricing can move so much, so quickly, I myself would have some sort of maximum percentage of the Option price as a mental Stop Loss if I was to use more than I was willing to risk in each position.

Another example would be to use technical levels on the stock chart or even percentages for the stock price as you asked about. If using either of these, I would still say it's a good idea to use much smaller amounts than typically used in your stock positions.

In this case, once the stock breaches a technical level on a chart, that should signal you were wrong in that particular trade, and you should exit.

As far as selling stocks if they reach a 25% draw down, I think this would typically be for a longer term investment. If you are willing to hold through a 25% price movement in a stock position, definitely use small Options positions as I mentioned.

A 25% gain on a $5,000 stock position is $1,250. Using a $500 or $1,000 Options position could produce this kind of return very easily that corresponds with the same 25% stock price movement. (Depending on the entry price of the Option of course).

I think it comes down to remembering that trading and investing is a long term commitment and strategy. Even while trading, the goal should be to produce profitable results over the long term. Don't use Options because you think you can make more money, faster. If you do, you are quite possibly concentrating on being greedy, or gambling too much rather than having successful, profitable trades and investments.

Using a Stop Loss on any investment is a method to help limit risk in your position. The ways I mentioned above help to limit risk by using smaller position sizing. Optional methods for more advanced Options traders and investors may want to look into purchasing additional Options at strike prices that may help limit the risk you have in each position. This is where it starts to get beyond my usefulness on the topic.

I hope what I have provided helps. Here is the link to my friends article that he wrote which may be of further assistance: Options and Stop Losses




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