More on Stops
Although the usual object of a stop is to prevent your equity from falling too much, a more persuasive motivation for a stop is to exit your position when the position becomes a wager with a too small or even negative expectation, or with a risk too great for you. And this ordinarily occurs when you find that the reasons you took the position no longer are valid.
For example, suppose you purchase an under-priced option, with IV = 30% but HV = 50%. In this case, you are counting on the HV to reassert itself in the price of the underlying. Suppose however that you are watching CNN or TRADEHARDNEWS.COM (coming soon) and learn that the company is being acquired at a fixed price. Ordinarily, this fixed price will be much larger than the current price of the underlying, but suppose it is in fact equal to the current price of the underlying, and suppose that the acquisition is to take place around the time of the option’s expiration.
Your original reason for taking the position was that its price represented a volatility too low in comparison with the historical volatility of the underlying. But now you have more information, persuading you, and the market, that the underlying will not experience the volatility you projected, but rather a lower volatility, or perhaps even no volatility at all. The positive expectation wager you took no longer appears to have the positive expectation that you thought it had. You should exit the position.
This is an example of a stop based not upon price but upon new information. It illustrates the point again that you should continually examine the assumptions that led you to take a position, and re-evaluate them at every opportunity.