Knowing what to buy and when to buy it is only half of the trading process. Savvy professionals will tell you that knowing when to sell is just as important, if not more important.
It’s all about controlling your risk. You must know in advance what has to happen to tell you when it is time to sell.
Simply stated, a stop-loss is a preset order to exit an options trade when the price of your stock, bond, commodity, or option falls by a predetermined amount. Thus, a stop-loss on an options trade prevents a small loss from becoming a large loss.
The typical stop is set at a specific price below where your stock or option is trading. You might set it by points or by a percentage.
For example, if you buy a stock at a price of $50 per share, you could set your stop at $45 per share. That means you’re willing to lose $5 per share before exiting the trade. Or you might have said you were willing to lose 10% before throwing in the towel.
In either case, if the stock drops to $45 per share, your stop order automatically becomes a market order to sell. In liquid markets, the odds that you well receive that $45 per share are high.
The same principle applies to options trades. Once you purchase an options contract, you can set a stop-loss to automatically sell your contracts if the price falls to a certain level.
This limits your losses if the trade goes against you, while still giving you the chance to claim the upside of options trading.
It’s pretty simple. But we can use different stop-loss strategies when trading options depending on your situation. Let’s take a look at why you might need to use stop-loss orders and how to use them effectively.
Why We Use Stop-Loss Orders on Options Trades
You use stops to control risk. Some people use mental stops, meaning that if their stock or option falls to a certain price, they will manually enter their order to sell.
However, mental stops are subject to the discipline of the trader – and even being aware at all that the stop price was reached. If you do not want to have to watch your quote screen all day, use formal stop-loss orders entered to your broker.
There is another reason to set stops. Let’s say you are riding a big winner, and its price keeps going up and up. You can adjust your stop higher as your stock rallies. That way, you lock in more and more profit without having to guess when to sell. In other words, you lock in your gain in the event a sudden pullback sends your trade back to a breakeven level.
This is called a “trailing stop,” and it’s entered the same way you enter a regular stop-loss order.
While most individuals can use the same method to set stops on all of their investments, there are times when you might want to modify them. For example, a stop on a volatile tech stock should be wider than a stop on a consumer defensive. The more volatile your stock or option, the more room it needs for its day-to-day wiggles.
If you’re expecting short-term volatility, setting a stop-loss close to the trading price could trigger a sell before you’re actually ready to sell. Conversely, setting a stop-loss too far away from the price of a more stable asset could mean you take heavier losses than you want before triggering a sale.
So before you set a stop-loss, make sure it matches your risk tolerance and expectations for the trade.
Now that you know the basics of how it works, here’s how to actually set up a stop-loss on an options trade…
How to Set Stops on Options
Setting stops is just as easy as entering a simple buy or sell order with your broker. If you are trading online, you will be offered a choice of buying or selling on your order screen. To set a stop-loss order on a position you already have, choose “sell.”
Next, you will enter the order type from the list of possibilities in the next box. Choose “stop-loss.”
Then, you enter how long you would like the order to be in force. For a stop-loss, you typically will choose “good until canceled.” That way, your brokerage account will keep track of the stock or option’s price for you and convert to a sell order if and when your stop price is reached.
After you fill in the rest of the information, such as how many shares of stock or options contracts, you enter the order.
It’s no secret that options trading can turn a good investing idea into a fortune. With the right research system, you will be able to navigate the universe of thousands of possible stock investments, choose the right ones, and then implement options strategies to take full advantage of the underlying stocks’ movements.
Stops can also help you feel more confident in real time with real money on the line. You will be able to make that trade knowing your risk is contained and no one trade will blow up your account.
Remember, options themselves limit your risk because their leverage allows you to control much greater amounts of the underlying stock with a small investment. If the underlying stock rises by 10%, it would not be unusual for its options to rise by 100% or more.
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Source: Money Morning