In options trading, risk management starts with defined risk and ends with position sizing. “Stop Losses” — if used at all — center around price action of the underlying and give zero weight to the value of the option(s) itself.
As an options trader, nothing makes me cringe more than hearing about traders “protecting” their open options positions with Stop Loss orders.
Don’t do it.
Options don’t trade like stocks or ETFs. They often have big bid-ask spreads. It is not uncommon for an option with a theoretical value of $2.00 to have a bid-ask spread of $1.50 x $2.50 — especially in a fast moving market where market makers get spooked and “step away” from the market.
If you had a Stop Loss order in to take you out when the theoretical value of the option hit below $2.05, your Stop Loss (which converts to a market order upon trigger) will get filled on the bid at $1.50 (if you’re lucky). That’s some enormous slippage!
Now, before you start flooding my inbox with messages about Stop-Limit orders, let me stop you right there. Yes…I acknowledge a stop-limit order will prevent your order from hitting a far away best bid or best offer. But if you’re relying on stops to manage your risk in options trades, the one time you really need that fill! on your stop-limit order will be one of those many times when your order has no chance of ever getting filled because the market moved away from you.
I don’t use stops on defined risk options trades. Instead, I make sure my position is small enough such that if I take a total loss on the trade, the dollar loss to my account is well within the range of acceptable for the size of my capital.
Once that is taken care of, then yes, I may watch some key price levels in the underlying and may wish to exit my options trade when the stock breaches a key support or resistance level. These may be “stop” levels, but they are actually simply triggers for me to then take action and work to close my options trade. There’s never a rush because my risk was defined and accepted up front when I first put the trade on.
I elaborate more in this episode of the Trading With @Chicagosean podcast, where I discuss the proper way to manage your risk in new trades and why stop loss orders (and by extension market orders) are a TERRIBLE idea in options trading. I hope you’ll spend 10 minutes with me to give it a listen: