Welcome back! I took a one-week hiatus from these Market Insights posts, but we’re back in full swing. The markets have been going absolutely crazy these last couple of weeks, so there’s definitely plenty to talk about!
However, I want to focus on wrapping up part 2 of the “why I trade options” discussion that I started in the previous post. Last time, I mentioned that there are strategies with options that let you make money no matter what the market does. Those can be very important strategies in a market that is very non-directional, like the one we’re in now. It’s critical to be able to maintain your “optionality” to be able to benefit from a shift in market momentum at a moment’s notice. Options let you do that.
Another ability that can be just as important is reducing risks while still maintaining profit potential. This is one of two main reasons that stock traders first start looking into options trading; in my experience: options have leveraged upside while at the same time having a built-in stop-loss that guarantees you can’t lose more than a certain amount of money.
If you buy 100 shares of a $50 stock, your max risk is $5,000. Sure, you can place a stop loss on that trade to try to prevent outsized losses, but that is not a perfect solution. When you place a stop loss on a stock, there are two types of orders to choose from: a stop market order or a stop limit order. The third type of stop order is a trailing stop order, which can be placed as either a stop market order or a stop limit order, so we will just focus on those two categories.
A stop market order is the type of stop loss that you’re most likely familiar with: if the stock goes down to or below your specified price, the order will trigger and exit you out of the trade at market price. A stop limit order is similar, except it will only trigger as long as it can get you out of the trade for a predetermined price or better once triggered. The problem with both of these is gaps. Imagine you bought 100 shares of a $50 stock and placed a 10% stop loss at $45. Bad news comes out about the stock, and the shares gap down to $38 overnight.
If you placed a stop market order, the order doesn’t fill at your stop level; it fills for the market price, which by this point is all the way down at $38. So rather than losing the 10% that you were prepared to lose, you’ve now lost a whopping 12% -- on 100 shares, that’s $1,200 down the drain.
If instead, you placed a stop limit order, it’s potentially even worse. When the stock gaps past your limit price, it won’t fill at all. That’s because a limit order only fills for the specified price or better. Since the stock gapped down to $38, the limit order never got a chance to execute at your limit price of $45. Now the stock could be in freefall and dropping further, and you are stuck with a limit order that gave you no protection.
Imagine instead, though, that you bought a call option on the stock at $50 instead. Let’s say the option cost you $4 per share, allowing you to control the same 100 shares as before, for a total cost of $400. Now, when the bad news comes out and the stock gaps down at the open to $38, your option is virtually worthless. You’re still looking at a loss on that trade. But the good news is that no matter what, you can’t lose more than you paid for the option. So worst case scenario, you’re out $400. It’s impossible for you to lose the $1,200 that you’d be out had you traded stocks with a stop loss instead.
It’s like a built-in stop loss, with the added benefit of being impervious to gaps. Unlike a stock with a stop loss, there is no way for the option to lose more than you paid for it. And similarly, unlike stocks, options give you a way to claw back a bit of that loss by selling options against your position, creating a spread. If good news came out about the stock instead of bad news and the stock shot up to $58, the stock position would be up 16%. But the options position would be up more than 100% as the value of the option would go from $4 to over $8 per share.
That’s just one way that options allow you to benefit from uncertain times. When you don’t know what the market is doing, it’s safest to reduce your risk. Options give you a way to keep your risk small and manageable because you become immune to gap risk with the option’s built-in stop loss. At the same time, you still maintain your leveraged profit potential, allowing you to capitalize on big swings in your favor.
As always, it is critical to follow a solid trading plan no matter what vehicle you choose for your journey. Conducting proper analysis, structuring your trades for asymmetric returns, and managing your risk wisely will all make huge differences with any asset class. So decide what vehicle is right for your journey. If you want to learn more about what options can do for your portfolio, I highly recommend you check out the options training available at TSU. We’re currently running a two-week boot camp to get you started trading options, and it’s totally free to join the live classes. If you’re interested in that, you can check it out here.