Using Stops with Defined Risk Options Trades

I have recently had many people ask about how to use stops in their options trades. My simple answer is that I don’t use stops with defined risk trades. Now you might be thinking “Wow, this guy is crazy to not use stops on his trades!”. Well the first thing to remember is that we are only talking about DEFINED RISK trades. By definition, when you enter a defined risk trade, e.g. selling a credit spread or buying a debit spread, you know your maximum risk for the trade as it is defined when you place the order. Say you placed a 495/500 call credit spread on AAPL for a $1.60 credit. Once you place that trade you know that your maximum profit is $160 and your maximum loss is $340 with approximately a 68% probability of success with the trade.  When placing this trade you MUST be comfortable with the maximum loss as something could happen to AAPL that could cause the trade to go to maximum loss. A common mistake people make that causes them to need stops is that they are trading too large a position so their account cannot sustain the maximum loss. When I trade options I make lots of small trades (more on this in a future post).

Another key reason not to use a stop on defined risk trades is that often the price will move against you at some point over the time you are in the trade. If, for instance, AAPL moved to $480 the spread would show a significant loss and many would stop themselves out and take the loss. The problem with this is twofold. First one has to keep in mind that if the position were to expire that day it would be a full winner and you still have time (duration) on your side. Secondly, stock prices will move up and down over the duration of the position. This leads to the concept of the Probability of Touch.  The Probably of Touch says that the probability of the stock price touching the short strike is 2X the probability of expiring ITM (in-the-money). Thus in our AAPL example there is approximately a 64% chance of AAPL touching $495 at some point while we are in the trade. Thus if we used a stop we are pretty much guaranteeing that we will be stopped out as based on the stops most people use (2X the credit received or sometimes less) the prices does not even need to reach $495 for a stop out to be triggered, thus turning a potential winner into a guaranteed loser.

Now does this mean that if the stock moves significantly against us we are looking at a max loss every time? Certainly not. There are several management techniques that can employed to either reduce the loss or scratch the trade. The key is to properly employ these strategies and also know when to just left the trade go. This gets back to the concept that you must be able to sustain the maximum loss for the trade.  Remember though that also long as there is time left till expiration you generally have options.

Note: This is a guest post from professional trader and longtime Become A Better Trader student, Randy Jacques.

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