The Cost of Losses--Options or stop losses-- which are better?

Discussion in 'Options' started by tradingjournals, Jul 30, 2010.

  1. Options or stop losses-- which is better?

    To limit loss, one can buy options, use stops or other loss cutting methods. Which is better? How would one decide between stop losses and buying option premium? Also please provide the other methods you use for minimize/cut losses. If your answer falls in the "it depends" category, please illustrate/comment.

    If you know of good threads that discussed this topic, provide URLs. Thanks.
  2. piezoe


    Excellent question! My guess is the answer will depend on your trading time frame, but I eagerly await the "wisdom" of our fellow ETers.
  3. If you think you have a defined edge with a specific price target in a certain situation (technical/fundamental or both), an option is better. Situations where the payoff is asymmetrical are good for options use but bad for trading the underlying because you can also loose big, i.e trading a biotech stock before an event data.

    But in most no binary event situations, most of the times the market churns sideways, or slightly up or down and it can kill your option. Its not the options fault, its just a consequence of a market. In cases where you're not sure on the timeframe, a stop loss is better because you'll have skin in the game from the entry, and a clean exit.

    Also, you need to make sure options are liquid on the underlying you're trading, otherwise you get grinded by slippage and bad fills.

    Ideally you're strategy should tell you to get in or stay out of the option and play the underlying.
  4. Puts in stocks in a downtrend after a few up days are probably better for shorting then shorting the stock. Reason is implied volatility goes now when prices rise so you can end up with a good price and the Put will have some degree, generally speaking that is of an upward pressure in price on implied volatility alone.
  5. Stop losses. Buying options is very expensive.

  6. spindr0


    It's hard to know what the OP is talking about. If he's referring to option protected stock then that's synthetic option buying.

    Which is better, buying options or stop lossing stock? Depends on your timing, selection, money management skill and if the gap hits you.
  7. I've always preferred options. I'm not a daytrader, though.
    With options, if a stock gaps you don't suffer nearly as much. If you get an opening gap and you've got a stop loss, and the price opens well below it (or above it if you're short) you've just lost a lot more than you bargained for. The worst is suffering a loss from that and then watching as it recovers fast and by 10 AM you're left holding a loss from the max down it reached at 9:35 that day, which wouldn't happen if you had bought options to protect you instead.
    Idea would be to figure out some reasonable volatility level for the extremes that the stock moves, and then buy protection somewhat inside there, but cheap enough not to cause you to lose much from a move in your chosen direction.
    Around earnings, I would put a collar on. I don't do stocks at all anymore, and with index ETFs you don't have to worry about earnings or huge gaps on the open. With stocks, you do. Stop losses just don't cut it for those morning gaps.
    Options are expensive because for those crazy gaps, they're worth it. In this as in everything, you get what you pay for.
  8. I think that the cost of stop loss orders are not as well understood as option prices. I did once a little mathematical model. I noticed that the average cost of the stop loss order would not behave like the price of an option in a number of ways. For instance, with regard to the location of the stop, the cost of the stop rises before starting to decline as the stop location is moved away from the stock.

    Do you use actual stops or mental stops? If mental stops when do you check (continuous/end of day/etc)?

    Actual volatility vs. implied are also important in the relative pricing.
  9. oraclewizard77

    oraclewizard77 Moderator

    If you think market will make a strong move, then buying an option allows you to benefit from that move with less risk than buying the stock.

    For example, I recently bought an AUG SPY put position, plan was short time holding say 1 - 4 days, this means even if I am wrong, I don't lose the total amount since there is still time premium left on the option.

    Overnight, the market went up and opened up which would have stopped you out if you were short the SPY.

    However, during the day, market sold off, and my option gained 20% in value.

    I then set a goal of 50% target for option, which it reached the next day thereby earning ROI% of 50% on the trade. Obviously, hard stop is the cost of the option, but I did not plan to hold till it was worthless.

    Also, option can act as a hedge if you are doing some long stock trades in case the market goes against you.
  10. Options as a hedge are best used when the market is highly volatile, erratic, and primed for a spike either way. This is how I use them in my trading. You must be good in predicting volatility though, and wait for the right volatility setups, otherwise you might end up making nothing for your time in the markets. It's even better if your hedged position is composed of options rather than stocks, futures, etc. Try to avoid flat volatility periods.
    #10     Jul 30, 2010