Stop Loss — Introduction

Stop loss is selling out of losing position when it is deemed to have little chance of turning around profitably or that when an options trader’s predetermined loss limit for that trade is met. Sounds really simple and straight forward, right? Simply sell when things are not looking good for your position. Fortunately or unfortunately, in options trading, there are many ways of performing this action of stopping loss. In fact, so many ways that almost all options beginners are bound to get confused on what they are and how to use them.

Profit From Any Market Conditions!

Learn how the author of Optiontradingpedia.com consistently pick the right stock for trading call and put options and make consistent profit under any market conditions! You would like to trade options like a pro too, don’t you?

What Does Stop Loss mean?

The term Stop Loss simply means stopping a position from losing more money. For instance, you have a bullish outook on QQQ and you buy its call options for $1.50. However, instead of rising, the price of QQQ begins to drop and the value of your call options drop to $0.50. You decide that that is as much loss as you are willing to bear for that trade and you sell the call options to salvage the remaining $0.50. That is a stop loss action.

Sounds pretty straight forward until you consider more customized actions such as setting your stop loss point based on the price action of the underlying stock instead of the options price. allowing the broker to automatically track and sell the options position only when it pulls back a certain amount from its highest price.

Options trading is truly the most versatile way to trade in the world not only due to the fact that options are the most versatile trading instruments in the world but also due to the fact that options brokers have come up with so many advanced, customized solutions for entering and exiting options trades and that includes many advanced and customized ways to stop loss.

In general, stop loss in options trading can be Stock Price Based or Options Price Based and they can either be manually or automatically executed.

The Simplest Stop Loss Method in Options Trading

As you can see from above, there are many ways of executing stop loss in options trading but if you are executing simple Long Call or Long Put options strategy, there is a way to ensure stop loss, losing only a maximum of your predetermined loss amount, right from the onset of your trade; Use only your intended stop loss amount of money for the trade! This means that if you do not wish to lose more than 1% of your portfolio on any one trade and 1% of your portfolio is $1000, you would then buy your call or put options using only $1000. When you buy options in a Long Call or Long Put options strategy, your maximum loss is limited to the amount of money you use in buying those options. This means that in the worst case scenario, the options you bought expire worthless and you lose all the money you use toward buying them, nothing more. As such, if you use only as much money as you are willing to lose on a single trade, you can never lose more than that amount, effectively, putting on a stop loss for your portfolio right from the onset.

Using Only Money You Intend To Lose Example

Assuming you have a fund size of $100,000 and you set your maximum portfolio risk as 1% per trade. This means that you wish to lose no more than $100,000 x 0.01 = $1000 in a single trade under the worst case scenario. You are bullish on QQQ and wish to buy its Jan50Call asking for $1.00.

You will therefore buy only $1000 / $100 = 10 contracts of the Jan50Call to ensure that the most you can lose in this position is $1000 or 1% of your portfolio.

Of course, going strictly by the definition for stop loss, which is to set up order or orders in order to stop a position from further losses, this method isn’t a real stop loss method per se but rather just sensible position sizing and trade planning which are essential steps in options trading. However, this is truly the simplest way beginners to options trading can predetermine maximum risk with complete certainty.

Options Stop Loss: Stock Price Based or Options Priced Based?

When you trade stocks, your stop loss decision can only be based on the price of the stock. However, because options are derivatives and derive their value from their underlying stock (or asset), their value can change as long as the price of the underlying stock changes. This happens even without the options themselves being traded. Stock prices only change when the stock gets traded but in options trading, options price can change with changes in the price of their underlying stock without the options being traded at all (this is measured by the options greek Delta ). This opens up the possibility of basing the stop loss of your options position on the price of the underlying stock instead of the price of the options themselves. This is known as Stock Price Based stop loss policy.

Stock Price Based stop loss policy simply means selling your options position when the price of the stock is deemed no longer favorable for the outlook of your options position. Here’s an example:

Stock Price Based Options Stop Loss Example