Use stops! That’s the message you read in the trading classics such as Schwager’s Market Wizards books or instructional pieces like William’s Long Term Secrets to Short Term Trading. The reader is implored to at least have a “catastrophic” stop order in place, just in case something crazy happens in the market.
Some trading educators teach that you should use stops to enter trades, as well as exit, on a systematic basis. But until recently, option traders have had some difficulty using stops since option stop orders are based on the price of the option itself…a dangerous proposition due to the volatile daily ranges that option prices can experience.
Another difficulty involves determining what option price to use as a stop. If the underlying asset hits a certain price, there is no guarantee that the option prices will move accordingly. This is due to large implied volatility changes that can occur day to day.
Fortunately, many brokers are now offering “contingency orders”; that is, your option order is executed when the underlying asset trades at a certain price. For example, you can have a resting stop order to buy call options if a stock ascends beyond a resistance level that you’ve identified.
This ability greatly enhances a trader’s flexibility in choosing how he interacts with the market. The volatile nature of options have made it such that traders typically watch a computer screen closely or at least have alerts set up so that they can execute exit trades quickly. The contingency order allows option traders to relax a bit by having resting stop orders automatically executed when a stock hits a certain price. No alerts required.
Figure 1 shows an example of a contingency criteria screen. Notice that this order is to buy 10 call options when the underlying stock advances to $60.
This kind of order ability now allows systems traders to more easily apply systems tested on the underlying asset’s price movement to options trading as well. A discretionary trader may want to use contingency orders for either catastrophe protection or as a methodical way to exit a trend.
An example of using a stop to ride a trend would be a classic fibonacci retracement ratio. Let’s say you notice that the price of a stock rose to a 61.8% retracement level from a previous decline. A reversal into the longer term trend could then be anticipated. Once this reversal occurs you would enter a trade (such as buying puts) that would profit if the long term trend continues.
How could an option trader efficiently exit from this trade? One idea is to use a five-day trailing stop. This means that you enter a contingency order to exit your position if the stock price rises above the highest price that occurred over the last five days. Of course, you would enter that price initially and then change it every day as that parameter adjusts.
When choosing a time frame to use, bear in mind that 5-day stops could also involve larger losses than 2, 3, or 4-day stops. Consider testing different scenarios and stops with real historical data using software such as the OptionVue 6 BackTrader module allows. If your broker does not offer a contingent feature as discussed, consider switching. Options traders need every edge possible and there is no excuse for not offering such a valuable service.