Stops in Option Trading
I have been asked how to use stop policies in options trading, and whether one should look at the price of the underlying and set stops that depend on the underlying’s movement, or whether the option price should be used. The general problem of setting stops in a portfolio is a little involved, but here is a brief discussion with a few general guidelines.
Although a sophisticated stop policy would constantly examine and update the profit expectation of each position held, traders use stops simply to prevent their total equity from falling too much. If you have an option position, the underlying’s action does not directly impact your equity, whereas the option price does. It is your equity that concerns you and thus you should look directly at the option prices.
If you are holding one simple option position, long or short,
you should look at your total equity and stop out of the position if your
equity declines by whatever your money management rules tell you. If you use a 2% stop rule, when your total equity declines by 2% you should close the position.
If you are holding more than one simple position, or have a
spread position, the strategies are the same as with any other portfolio. The basic principles are:
- The asset you own is the option or spread and it should be treated
like any other asset in your portfolio. Unless you have highly sophisticated models — more sophisticated than those of LTCM, for instance — the fact that its value is related to another asset (the underlying) is not relevant. - The market tells you the net worth of your portfolio every day, and
you must acknowledge that and act accordingly. If you have a well
constructed spread and the spread has a net edge but moves against you, you will probably find that the edge has become even greater and you would presumably be foolish to close out the spread; you may even be tempted to increase the size of your position.
Note, however, that the edge is really a function of the various estimates and assumptions that you have made in entering the spread, and you should constantly re-evaluate those estimates and assumptions, especially if the market declares a different opinion. The edge may be illusory and due to faulty estimates (for example, of volatility). On the other hand, even the market is sometimes wrong. But be vigilant. I will say a bit more about this on Thursday.