How to Use Options as Risk Control in Volatile Conditions
by Dan Keegan
Originally published in Futures Magazine on 4/01/10
Options are often a better risk management tool than stop orders. A stop order is an order to buy or sell a stock, futures contract or exchange-traded fund when a specific price point is triggered. This helps to establish a defined exit point for the trader. Stop orders become market orders as soon as the security goes beyond the trigger price. Traders who are followers of technical analysis use stop orders at key support and resistance points.
A stop loss order is entered to prevent further loss to a trader’s position. As an example, letâ€™s say that a trader buys a futures contract on April gold for $1,122 an ounce. The trader wants to define their risk to the downside. Letâ€™s say that they will not tolerate losses greater than 10% of their investment. The trader can enter a stop loss order at $1,010 an ounce. If gold trades below that level, the order becomes a market order and the traderâ€™s position is closed out. If the trader shorted the April futures contract, the stop loss order would be placed at $1,234 an ounce. The short position is bought back at the market as soon as April gold trades beyond $1,234 an ounce. That trade would require an account of more than $100,000. If the traderâ€™s account was say $25,000 and he wanted to limit his loss to 10% of that account, he would need to place a stop $25 away from the entry (a gold futures contract is based on 100 oz.), less, if he takes into account the real possibility of slippage.
Letâ€™s compare stops to the use of options. Take IBM trading at $127 as an example. If a trader buys IBM at $127 they can set up stop loss orders at 5% or 10% below the current market price. That would be $120 or $113.70. They could also buy an IBM March 120 put for 54Â¢ per share. Listed options contracts generally represent a round lot (100 shares) for stocks and exchange-traded funds. For futures, one option equals one futures contract. This put contract gives the trader the right to sell 100 shares of IBM at $120. If a trader has to pay $54 for the put contract and pays nothing for the stop loss order, why would any trader ever buy a put?
A couple of reasons: First, what if some terrible news came out on IBM and it opened at $100? The stop loss order would be executed at $100 for a loss of $2,700 (so much for your risk management parameters), while the put that the trader bought would be worth at least $20 per share. Second, there is another and equally compelling reason to use the put over the stop order. When the trader uses a stop order they are permanently smoked out of their position. Letâ€™s say that IBM traded at $119 and then ricocheted back up to $127. The buyer of the put would still be long IBM, while the trader who used a stop order would have a $7 ($700 on 100 shares) loss and would be on the outside looking in.
Letâ€™s use the same logic for the trader who shorts IBM at $127. If the trader can only tolerate a 5% loss, they can place a stop loss order above the market at $133.35. The trader also can buy either an IBM March 130 call at $1.10 per share or a March 135 call at 20Â¢ per share. A call option contract allows the purchaser to buy the stock at either $130 or $135 per share. The less protection provided by the call, the smaller the premium for the call option. If IBM gaps up to $150, the trader who used a stop loss order is then buying their stock back at the $150 level, while the buyer of the 135 call is already $15 in the money. Similarly, if IBM trades at $135 and then drops back down to $127, the call buyer still maintains their short position.
Options work better than stop loss orders for two very important reasons. They donâ€™t face the very real risk of slippage when a market blasts through a level congested with many technical based stops, and they can withstand more pressure and maintain the opportunity of the initial positions.