PowerRatings, Stop Losses and Options: Tips for Short Term Traders
We are often asked why we do not use stops when making high probability PowerRatings trades and, importantly, what we use instead of stops in order to limit risk.
It is true that we do not trade with stops. Our research has consistently shown that for both stock and ETF trading strategies, stops actually decrease performance. While this might seem odd, virtually every trader has the experience of seeing a trade get stopped out prematurely, only to have the market recover and continue on its previous course. And though most traders have anecdotal experience of this, our testing suggests that this scenario happens far more frequently than traders might suspect.
Another problem with stops is that they do nothing to protect against overnight risk. A stock that gaps down overnight due to some news or market-moving event will leapfrog right over any stop-loss that was put their to “limit risk.” If you have a stock that closes at $25 and opens the following session at $15, there is not much a stop at $20 will do to protect you.
So how do PowerRatings traders limit risk when trading high PowerRatings stocks? One tactic is to use options trading strategies that allow traders to decide in advance just how much capital will be at risk. Even simple long call and long put positions in high PowerRatings stocks can be a great way to avoid using stops as a primary risk control tool.
When it comes to using options as, essentially, stock replacements, we strongly encourage traders to use deep, in-the-money calls and puts. While out-the-money options provide greater leverage and can potentially boost returns, we have found that deep-in-the-money options do a much better job of tracking the underlying stock than do out-the-money options. This is especially important for short-term traders. Additionally, the fact that deep-in-the-money options have intrinsic value means that those occasional losing trades will like result in far less costly drawdowns compared to trades using out-the-money options.
Liquidity is another issue for traders using options to trade PowerRatings stocks to consider. Less liquid options tend to have larger bid/ask spreads, potentially increasing the cost of the trade. So in addition to sticking with deep-in-the-money options when it comes to high PowerRatings stocks, traders should check to make sure that there is a healthy and liquid market for the options they are looking to buy.
Does your stock trading need a tune-up? Our highest Short Term PowerRatings stocks have outperformed the average stock by a margin of more than 14 to 1 after five days.
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David Penn is Editor in Chief at TradingMarkets.com.