I’m sure you have heard that one of the best ways to control risk is to use stop loss orders. Well if you are trading options directional, stop loss actually guarantee that you will loss money. Just to be clear I do believe that you have to have systems & strategies in place that control risk and minimize your losses. But stop loss orders don’t work when in comes to trading options. If you have ever been in a position where your stop loss order was triggered just to watch the stock recover a few days or even hours later. then you know what I’m referring to and trust me I have been there. It can be very frustrating, to say the least, your left with a realized loss in your account and no position to take advantage of a move in your direction.
From my own trading experience and working with other options traders, I have found three main reasons why stop orders don’t work in directional options trading, and in fact will cost you money.
There are many factors that go into the pricing of an option one being implied volatility. Changes in implied volatility will result in changes in option pricing. News events may result in sudden, and temporary changes in implied volatility which will result in changes in option pricing. These changes in implied volatility create situations where stop loss on options can be triggered even if the stock or etf are still performing to your satisfaction.
The second problem with using stop loss orders on options, is time decay. When you buy a option each day that goes by you have time decay working against you. When price action doesn’t go in your favor you have a double edge sword working against you. Not only is the price action going against you but the option is also losing value due to Theta. This creates a situation where options are losing value at a faster rate than the underlining which can result in your stop loss being triggered.
Market volatility & computer driven markets make stop loss even more dangerous. The simple fact is that market volatility can move prices below or above a certain level triggering stop loss orders. These moves many times are temporary and can be driven by computers. The best example of this was on May 6 where we saw the DOW drop 1,000 points from computer trading, just to recover s few minutes later.
The fact is that options are not stocks and they have to be traded differently. If you are trader that wants to use options to take advantage of market, sector, or stock trends, we recommend option strategies that enable you to reduce the effects of market volatility, implied volatility, and time decay.