What’s Better Than Stops?

September 12, 2024
Larry Connors

Larry Connors' Trading Lesson of The Day | September 12, 2024

In the past three lessons, we looked at the many reasons why stops are not the fool-proof risk management tool that so many people advocate.

We learned how one of the legends in the hedge fund and trading industry, one with decades of tremendous performance, stated he never uses stops.

We then discussed the many shortfalls in stops, especially the fact that they don’t provide you with any protection when the markets are closed. Overnight and weekend risk makes up the majority of hours every trading week and stops don’t provide any protection the majority of the time.

Also included was the fact that stops tend to accumulate losses, are sought out by high-level computer programs created by the top trading firms in the world who gladly take out stops and then reverse prices higher, along with a number of other factors few people mention when they say your stops fully protect you.

By now you know they don’t.

Yesterday, we looked at unbiased large sample size data that showed that stops, as far as 50% away, lower returns. No matter where the stop level was placed, performance was hurt.

Today, let’s go into solution mode. Can you protect your trading positions better with ways other than stops?

The answer is a resounding yes.

Better Risk Management To Enhance Returns

There are numerous ways to structure your trades without using stops. I’ll list the top three, used primarily by professionals. There are also 3-5 more advanced strategies that can be applied – these are beyond the scope of today’s lesson, but I may cover them in the future. The three here, though, are highly favored. Also, if you have the skills and knowledge to go deep with AI, you’ll learn even further why they’re ranked amongst the best.

1. Options

In an earlier Trading Lesson of the Day, I mentioned three of the best options trading books that you’ve likely never heard of.

One was by professional trader Euan Sinclair titled Positional Options Trading.

Euan has successfully traded derivatives for major firms and I strongly encourage you to read his book if you are an intermediate to professional-level trader.

He, like Stanley Druckenmiller, is not a fan of stops.

In his book, he has this to say about stops compared to options… “Stops will kill some trades that would have eventually have recovered. Options won’t do this, and this is the benefit of paying the premium”.

What Euan is saying is that in exchange for paying some time premium, your ability to stay in the position will often get extended.

Instead of getting stopped out and accumulating the loss, options keep you in the position longer. And the times that they reverse back in your direction, they take a sure losing trade caused by the stop and potentially turn them back into winners. When the reversals are strong, they will at times turn your trade into large winners.

As we know, it’s not fun seeing a position we have conviction in get stopped out, the loss is booked, and then the position reverses significantly. With stops, it’s a loss. With options, it’s a potential gain, and at times, there will be gains that could make your week, month or even year depending on your position size and the size of the move.

Which options should you trade? In my opinion, they’re the In-the-Money (ITM) options, dated based upon how long you expect, on average, to be in the position.

Let’s dive deeper into why ITM long calls can be an excellent tool for managing risk while pursuing significant returns.

In-the-Money (ITM) Long Calls: A Powerful Asymmetrical Strategy

Explanation:

⏵ Defined Risk: When you purchase an ITM call option, the maximum risk is limited to the premium paid for the option.

This predefined risk is a crucial advantage for you, as it allows you to control potential losses without the need for stop-loss orders.

⏵ Asymmetrical Returns: The real strength of ITM long calls lies in their potential for asymmetrical returns.

With a small, defined outlay (the option premium), you gain exposure to significant upside if the underlying position appreciates. This can result in substantial returns relative to the initial investment.

⏵ Intrinsic Value: ITM calls have intrinsic value, meaning they are already profitable to some extent if exercised. This provides a “head start” in capturing gains if the underlying stock moves in your favor.

Why ITM Long Options Are Superior to Stops

1. They Avoid Premature Exits: Unlike stop-loss orders that can trigger due to temporary price movements, ITM long calls allow you to stay in the trade through short-term volatility. You won’t be forced out of your position unless the option expires worthless.

2. Leverage with Limited Risk: ITM calls provide leverage, allowing you to control a larger amount of the underlying asset for a smaller upfront cost. This leverage is paired with limited risk, as your potential loss is capped to the premium paid.

3. Asymmetry in Payoff: The beauty of ITM calls is the asymmetry in their payoff. Your downside is limited and known, but your upside is theoretically unlimited, depending on how much the underlying stock appreciates before expiration.

I especially like this. Asymmetrical trading is often the backbone of superior performance and wealth creation.

4. Better Probability of Profit: ITM options have a higher delta (sensitivity to the underlying stock’s price movement), meaning they are more likely to end up in the money. This makes them a more conservative yet still powerful tool compared to out-of-the-money (OTM) calls.

5. No Need for Stops: With the maximum risk predetermined, there’s no need for you to set a stop-loss order. The option’s expiration and intrinsic value act as natural boundaries for your risk and reward.

Purchasing a stock outright costs more money than an ITM option, tying up additional capital. Theoretically, this larger amount of capital is fully at risk. With short positions, the risk is unlimited.

With long option positions, your risk is pre-defined. This means you go to bed at night knowing exactly to the dollar what your risk is. No matter what happens in the world or to the company, you sleep well knowing what your max risk is ahead of time.

Examples of Using ITM Long Calls with Stocks and ETFs

1. ITM Long Call on AAPL (Apple Inc.)

⏵ Scenario: Apple is trading at $225, and you anticipate a strong earnings report that could drive the stock higher. However, you want to limit your risk.

⏵ Action: You purchase a $220 strike call option that is expiring in three months. This call is ITM and might cost $10 per share ($1,000 per contract).

⏵ Outcome: If AAPL rises to $250 by expiration, your call would have an intrinsic value of $30 ($250-220 ), providing a substantial return relative to the $10 premium paid. Your risk was limited to the $10 premium, and the potential return was significant.

2. ITM Long Call on SPY (S&P 500 ETF)

⏵ Scenario: You are bullish on the broader U.S. market and expect a rally in the S&P 500. SPY is hypothetically trading at $550.

⏵ Action: You buy a call option with a $540 strike price, expiring in six months. This ITM call has a high delta, offering good exposure to SPY’s price movements

⏵ Outcome: If SPY climbs to $600, your option’s intrinsic value increases to $60 ($600 – $540). With an initial investment perhaps around $20, this offers a substantial percentage return, all while capping your maximum risk to the premium paid.

There you have it.

1. Fixed risk (known ahead of time).

2. The potential for asymmetric returns on your capital when you’re correct.

3. Less capital required.

4. No risk of being stopped out, nor having open ended risk if the market or stock has an extreme adverse move overnight.

Conclusion

ITM long options are a highly effective strategy for professional traders who seek to balance the potential for substantial upside with predetermined risk.

The asymmetrical payoff structure allows you to participate in substantial market moves while limiting your downside to the premium paid for the option.

By using ITM long calls, you can maintain exposure to significant opportunities without the pitfalls of stop-loss orders, making it a superior risk management tool in many scenarios.

This is how many professional trading firms structure their trades. They’re looking to take the least amount of risk, in order to put themselves in the position to make many times the amount of money they’ve placed in the trade.

2. Conviction-Based Sizing

Conviction Based Sizing is used by many top performing managers including traders like Druckenmiller all the way to long-term investors like Warren Buffett (Druckenmiller said stops are the dumbest concept he ever heard. Buffet has likely never mentioned the word “stops” in his life).

Conviction-based sizing is an investment strategy where you allocate more capital to trades or positions you have the highest confidence in.

The idea is to increase your exposure to opportunities where you believe the risk-reward profile is most favorable, based on thorough research or strong market signals.

This approach maximizes potential returns on your best ideas while minimizing risk by reducing exposure to lower-confidence trades. As I mentioned, it’s used by many top traders and investors.

“Bet Big and Bet Infrequently” is their philosophy.

Why Conviction-Based Sizing is Better than Stops:

⏵ Conviction-Based Sizing Leverages Deep Research and High Conviction:

For example, Druckenmiller’s approach concentrates heavily in a few positions. He has deep conviction and does thorough research when putting on positions

Conviction-based sizing involves allocating capital based on the confidence level in a position, rather than diversifying widely.

This allows for maximizing returns on high-conviction trades while carefully managing the risk through precise position sizing.

Stops, in contrast, will undermine this strategy by forcing an exit based on short-term price movements rather than long-term conviction.

⏵ Dynamic Adjustment Without Forced Exits: Unlike stops, which can abruptly remove a position, conviction-based sizing allows for dynamic adjustments in position size based on evolving insights and market conditions. This flexibility is crucial in maintaining large positions over time without being prematurely stopped out by market noise.

This approach is more hands-on than a simple rule based system. Its strength lies in the fact that it’s flexible, and has the potential to make tremendous returns when you’re correct.

Additional advanced concepts, like Kelly-based position sizing and using derivatives (including options), to reduce the capital risk while optimizing the gains, also play roles.

If you are an intermediate term to long term trader, I highly recommend you study this approach. Based on the decades of success from so many hedge funds applying this, it’s worth putting in the time.

3. Options Hedging

What is Options Hedging?

Options hedging is a strategy used by traders to protect their investments from potential losses.

It involves you buying or selling options to offset potential losses in your existing stock or ETF positions.

For example, if you own shares of a stock and you’re worried about it dropping in price, you can buy a “put” option. This put option gives you the right to sell your shares at a predetermined price, even if the market price drops below that level.

Essentially, options hedging acts like insurance for your trades.

Why is Options Hedging Better than Stops?

There are 4 main reasons options hedging is better than stops.

They are:

1. Controlled Risk: As I mentioned earlier with the ITM options, you know exactly how much you stand to lose.

Stops, on the other hand, might trigger at the wrong time due to short-term market fluctuations, forcing you to sell at a loss even if the stock later rebounds.

2. Flexibility: Options let you stay in the trade and potentially benefit if the market turns in your favor, whereas stops simply exit the position and prevent any further gains.

3. Potential Income Generation: Certain options strategies, like covered calls, can generate additional income while still offering protection, something stops cannot do.

I can write an entire guidebook on the number of ways to bring in additional income while in a trade. It’s vast, and learning how to do so has the potential to increase your annual returns by a healthy amount.

4. Avoiding Market Noise: As we’ve discussed throughout, stops can and often do get triggered by temporary market whipsaws, causing unnecessary exits.

The large data set example you saw yesterday in Short Term Trading Strategies That Work is an example of just how much whipsaw markets eat into historical edges when stops are applied, no matter how narrow or large the stop is.

Summary

Options hedging is a powerful tool for managing risk in your investments.

It offers more flexibility and control compared to stop-loss orders, allowing you to protect your portfolio while still participating in potential gains.

By using strategies like protective puts, covered calls, and even collars (I’ll cover this at a later date), you can tailor your risk management to your market outlook and individual positions, making it a highly effective strategy often used by professional traders.

There are additional strategies that can be used that are better than stops. They include diversification, minimally correlated positions (a favorite of billionaire hedge fund manager Ray Dalio), statistical arbitrage, and volatility-based positions. Each is a study by itself and I’m placing them here for you should you decide you want to study each further.

As a whole, if you want to keep it simple, focus on the options trading strategies. Each strategy has its own strengths, allows for asymmetrical returns while limiting risk, and are far more flexible and scalable than stops.

As a final reminder, if you’re already using stops and are satisfied, continue using them.

Also, my focus in these past 4 lessons has been on positions that are held overnight. With day trading, using stops, in my opinion, are better than no stops. Over the years, I’ve published a handful of intra-day strategies for trading equities, ETFs and especially volatility (trading VXX). All have stops in them.

As a whole though, these past 4 lessons are here to give you a full picture of stops, especially their weaknesses. You’ve now seen this through the eyes of other top traders and hedge fund managers and through the use of data.

You also see there are better alternatives: those used by professional trading desks and hedge funds who look to maximize their gains while reducing their losses.

I’ll see you tomorrow with a new trading lesson!

Larry Connors

Disclaimer: Nothing in this e-mail should be considered personalized advice. The Connors Group, Inc. (“Company”) is not an investment advisory service, nor a registered investment advisor or broker-dealer and does not purport to tell or suggest which securities or currencies customers should buy or sell for themselves. Although our employees may answer your general customer service questions, they are not licensed under Federal and State Securities law to address your particular investment situation. Hence no communication by our employees to you should be deemed as personalized investment advice. Furthermore, the analysts and employees or affiliates of Company may hold positions in the stocks, currencies or industries discussed here. You understand and acknowledge that there is a very high degree of risk involved in trading securities and/or currencies. The Company, the authors, the publisher, and all affiliates of Company assume no responsibility or liability for your trading and investment results. Factual statements on the Company’s website, or in its publications, are made as of the date stated and are subject to change without notice. Company assumes no responsibility or liability for any trading and/or investment results that you may obtain by using such information. It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable or that they will not result in losses. Past results of any individual trader or trading system published by Company are not indicative of future returns by that trader or system, and are not indicative of future returns which be realized by you. In addition, the indicators, strategies, columns, articles and all other features of Company’s products (collectively, the “Information”) are provided for informational and educational purposes only and should not be construed as investment advice. Examples presented on Company’s website are for educational purposes only. Such set-ups are not solicitations of any order to buy or sell. Accordingly, you should not rely solely on the Information in making any investment. Rather, you should use the Information only as a starting point for doing additional independent research in order to allow you to form your own opinion regarding investments.

You should always check with your licensed financial advisor and tax advisor to determine the suitability of any investment.

HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING AND MAY NOT BE IMPACTED BY BROKERAGE AND OTHER SLIPPAGE FEES. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.