Lessons from the Pros


More Stops on Options

In last week’s article, which you can read here, I talked about setting stop-loss orders on option trades. More on that subject today.

As I noted there, an option strategy often involves multiple individual positions, or legs. Last week’s example was a covered call, which has two legs: a long stock position and a short call position. If we want to completely exit the strategy, we need to close all of the individual positions. In the case of the covered call, that means selling the stock and also buying to close the short call. “Buying to close” is what we do in order to exit a position where we have originally sold an option short (like a covered call). Besides “buying to close,” exiting a short option position is also variously referred to as “buying back,” “buying in,” “buying to cover,” or just “buying.”

I said last week that entering stop-loss orders that will automatically close out all of a position’s legs is possible, as long as our trading software has some basic capabilities. The easiest way is with spread orders combined with conditional order capability (like Think or Swim and some others). Next best is with Order-Sends-Order capability together with conditional orders (like Tradestation and some others). I gave the details of exiting a covered call position using Tradestation’s method last week. Other positions are done in a similar way. The same principles apply.

There is one thing that is unfortunately true for stops on options in all software platforms: The order type must be Market. It can’t be Limit, which we normally prefer; we do not know what limit price(s) to specify. That’s because we don’t know exactly where the prices of the options will be when the underlying hits our stop price. We just know that we need to get out then. The market order(s) are kept from executing immediately by applying a condition to them, the condition being that the underlying goes past our stop price.

The procedure for setting up stops is as follows:

1.      Identify the stop price.

Identify the price of the underlying asset at which your opinion as to its direction will be proven wrong. This is the same price where you would cut your losses and exit the trade if you were trading the underlying asset itself. It is below a nearby solid demand (support) level for bullish trades, or above a nearby solid supply (resistance) level for bearish trades. If you need help on this point, educate yourself on technical analysis. Options do not negate the need to forecast price direction.

2.      Create the exit order(s) as market order(s).

a. If your platform has the capability for spread orders (multi-legged orders) with conditions (Think or Swim, etc.), set up the order to exit all legs of the position as a spread order.

b. Otherwise, If you do not have the capability for spread orders with conditions, but you do have Order-Sends order capability (like Tradestation), then just set up a single order to exit one leg of the option position. If the position has both short and long legs, then this initial order should be to close out one of the short ones.

c. If using OSO, now attach the orders to close out the remaining leg(s). The exact process was shown in last week’s article.

3.      Apply the condition

Apply a condition (or contingency or order rule, depending on your platform’s terminology). The condition is that the underlying goes beyond your stop price.

The above process can be used to close out any number of legs. If using OSO, we just have to make sure that we close out the short side of any long-short pairs before the long side, so that the short side is never naked.

Rolling as an alternative to stops

Fine, we can do stops. But there are times when we do not want just to exit the whole position if it goes against us, but rather to do something else. Usually this means closing out part or all of a position and replacing it with a different variation of itself. This is called “rolling” the position.

Here’s a simple example. A short put is a strategy that we might use on a stock that we think will be sideways-to-up in the near future. If we’re correct and the stock stays above the put strike price, then the put expires with no value, and we keep the amount we received for selling it as our profit. If we’re wrong and the stock moves down, we could lose, potentially a lot.

We could guard against too big a loss by simply using a stop on our short put position. This would be just one order to buy-to-close the put at market, contingent on the stock price being at or below a stop price. No OSO or spread order would be needed for this simple stop, since there is only the one leg.

But perhaps there is a “fallback” price not too far below the first stop price, which we believe is very likely to hold. We could then plan to salvage something out of the trade if the stock price reaches our first stop. This would be done by replacing the first short put with one whose strike price is below the farther stop price. We could “roll down” the position by buying back the original short put, then selling another put at a lower strike price. Selling the lower put gets us back some of the money that we have to pay out to buy back the first one. If the stock then stops falling and does not drop through the lower put strike, the new put will expire worthless. We will have recovered some of the money that we lost on the first short put.

Sometimes by the time the stop price is reached, enough time has gone by that we now feel comfortable selling the replacement put at an expiration date that is farther in the future than the original one. In that case the new option we’re selling will have more time to run and will be more expensive; we’ll recover more of our loss that way, and possibly all of it or even more. This is called “rolling out.” If the new option we sold was both lower in price and farther out in time than the first one, we would be “rolling down and out.” Of course we can roll up, or up and out, as well.

Rolling is not a get-out-of-jail-free card. There is a cost to doing it, as compared to just getting completely out at a stop. The cost is that instead of cutting our losses at a known amount, we extend the risk on the trade. Our eventual loss could be more than it would have been had we just taken our lumps with the original stop. We have kicked the can down the road. Sometimes that works, but sometimes you run out of road. Before deciding to roll, we should be sure that we are very confident in the new strike price.

We’ll talk more about rolling another time.

For questions or comments on this article, contact me at rallen@tradingacademy.com.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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