Options for Day Traders:
The September S&P futures contract is currently trading around 1415. Suppose you are an S&P day trader and take a long position at 1415. If you are an experienced trader, you will always trade with a stop. (Even if you are merely doing a trade as innocuous as an option write, always have an “uncle point” at which you will abandon the position; to trade without stops is suicidal and will, with 100% certainty, eventually lead to ruin). Suppose you set your sell stop at 1406.
The object of the sell stop is to get you out of your long position if the market moves against you by a certain amount. Your sell stop may be in the market as a resting order, or it may be in your mind, or it may reside on your broker’s desk. You should realize that none of these stops is foolproof, not even the resting market stop order.
For your sell stop to be executed, there must be buyers who are interested in buying when the price falls to your sell stop price. But if there are no buyers at that price, the market will fall to a point where there are buyers, and this can be a considerable distance if the news is particularly negative.
The S&Ps have an August call with a strike price of 1450 selling for around $12.50, and an August put with a strike price of 1375 selling for around $23.00. If you are an active day trader, you sometimes will be long and sometimes short, and in addition to your stop-loss order, which may fail, you may want catastrophe protection, both on the downside and on the upside.
To protect yourself from a failure of your stop to activate, you can purchase the 1450 call and the 1375 put at a total cost of about 36 S&P points. With 24 days to expiration of these option contracts, your cost amounts to about 36/24 = 1.5 S&P points per day, a reasonable insurance premium if you are an active day trader. The position consisting of an out-of-the-money (OOTM) call and an OOTM put with the same expiration is called a strangle.
This strangle will provide you with protection in case of an extreme move of around 35 points in the S&P when you are either unable to execute a trade or are caught totally by surprise by the market, in the way that the day trader was whom I mentioned in the last commentary (who by the way had a sell stop in the market at a price about $400 below his entry and yet lost $10,000 for precisely the reason outline in the last paragraph–the market dropped 40 S&P points before finding buyers).
If the S&P futures contract falls, you will begin gaining from the 1375 put as its value increases. When the S&Ps are at 1375, the put will have a delta of about 1/2, and you will gain about $0.50 for each dollar lost by your long position. For more protection, you can purchase two puts and two calls, which will ensure that if and when the S&P falls to the strike of 1375, your put position’s gain will offset the losses from the S&P’s further decline more or less entirely, and will even produce a net profit if the S&P falls much further.
You could also look at September strangles–the September 1450/1375 strangle costs about 53 S&P points, but there are 45 days to the expiration of the September contract, so the daily cost is only 1.18 S&P points. These protections cost less than the total slippage you will experience on a few trades, and if you are an active day trader the cost will be minor compared to the value and the peace of mind they provide.