Why Stops Are Important For Options Traders

Stop losses are a very important topic in trading with strong opinions divided in to two general camps, traders who use stops or traders who don’t. First let me start with defining what I mean by a stop loss, I am referring to a stop loss as a physical order placed with your broker/trading platform at a specific level where you will manually exit a trade. The stop is either a level in your head where you plan to exit a trade or an actual stop order placed with your broker. Each trader will benefit from having a plan for an exit on every trade, whether the trade works for you or not.

Stops in options trading can be set in a few ways including; Placing a stop order with your broker based on dollar amount risk, Position sizing so the entire cost of the option is your stop, (for example you buy a call option for $0.40, the entire cost of the option is your stop), using limited risk strategies like spreads (where you can set the maximum risk when you place the trade) and the “mental stop” where you exit a trade when you see price reach a certain predetermined level.

Trading with or without stops can be widely discussed with different opinions based on different traders perspectives and depending on the trading instrument, futures, options or stocks. Personally, I believe that everyone should have a plan to place some kind of stops, but the stops should always be relative to the trading instrument and the range that price of that trading instrument will typically move.

Unfortunately, placing stops based on dollar amount alone or number of contracts traded (which is what the majority of trading books discuss) falls short of valuable details in stop loss decisions. The details of your trading style and support and resistance levels play an important role in stop loss management. If you keep getting stopped out and the market reverses, it might be because your stop loss is above key levels of support or below key levels of resistance. I would argue that stops and targets should be adjusted for each trade taken, and not a one size fits all approach.

There is no hard and fast rule for setting stops, however I believe that stops need to be set based on 4 factors:

1) Size of your account and the percentage of your account you are willing to risk on each trade.

If you are willing to place riskier trades, then you will also need to realise that trades will go against you. Ensure that you have designed your trading plan to reflect the profit and loss targets that will still equate to a positive sum. Even aggressive traders will need stops that are still aligned with the amount of money they are willing to risk on each trade and accounting for some trades that will work and others that won’t. Interestingly, in my experience having coached thousands of traders, most traders are better able to take a stop than wait until their targets are hit. What happens is that traders will use a wide stop and let that stop be hit before exiting the trade, but are quick to take profits on winners with a very small amount. This too quick profit creates a risk/reward ratio biased to the down side. New traders often get excited when a trade is moving in their favor and may exit a winning trade too soon but let a loser run for too long.

2) The instrument you are trading (e.g. volatility of the trading instrument) should help you adjust the stop and profits.

If you are a trader who likes to take quick profits then you need to adjust your stops accordingly and take small losses. Contrast that with a trader who is able to hold winning trades, they can also have larger stops since their winners are larger as well. A stop level will be set differently in each market and to accommodate different trading instruments because some stocks are more volatile than others. I would not try and trade BIDU in the same manner that I trade IBM or Gold the same way I trade the S&P 500. You cannot base your stops on dollar value alone, you need to also base the size of the stop on the volatility of the instrument you are trading. If you trade a volatile instrument with tight stops you might be right on the trade but you will be whipsawed in and out of the trade. It can be very frustrating to have the correct assumption about a trade, but still lose money because your stops were set too tight.

When you create your trading plan you need to make accommodations for the volatility of the instrument you are trading. Make sure your stop is mathematically relative to your profits. A traders goal is to consistently make money and control their losses. It just doesn't make sense to set stops at a level where even if 4 out of 5 trades work in your favour, if the fifth trade will wipe out all of your profits from the previous trades.

3) Your trading personality linked with trade set ups you like to use

When you are able to identify how much risk you are comfortable taking, you can also make decisions based on trade strategy that you are most comfortable with. Trading by selling a naked put which has unlimited risk, will need to have a plan upon a losing trade whether you have a stop loss or plan to take assignment of the stock. If you are a trader who prefers to trade at the money, with more risk, you may determine stop losses based on a combined level from support in the charts and the dollar value loss controlled by the width of the spread.

4) Anticipated targets for the trade. (e.g. Support and Resistance)

In order to overcome any temptation to undermine your profit and stop decisions, traders need to set targets and stops not based on what they hope to make in profit, but rather based on what they have observed a trading instrument move in the past. Support and resistance are important when looking at stop levels. Stop levels which coincide with support levels are much more likely to hold. This becomes even more important for options trades that last longer and have more volatility. For Futures stop levels also needs to be aligned with market movement based on an indicator such as the ATR.

Remember that markets change on a daily basis and even faster on an intraday basis, it is for this reason that your stops will constantly have to be evaluated as part of your trading considerations before you place a trade. For example, Apple NYSE:AAPL might be moving $1.50 per day and then quiet down to where it may only move $0.35 per day. Determine your stop levels based on the market action you are seeing at the time you place a trade.

It will take time to develop a good eye for setting stops based on the four factors mentioned above and also time to develop the confidence to trust your stops and profit ratios. Experiment in your paper trading account until you have found a stop loss trading routine that incorporates all four factors.

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