Options: How A Million Dollar Options Trader Sets His Stops:
Underhanded Tips and Tricks
When a options trader understand that it is important to set
stops on all their positions, they often don`t know where to set
them. As a options trader, how close should a stop be to price
of the position they are entering? Should they be tight, set
quite close to the price, or a little looser? What about
trailing stops? Here are some factors to consider that will help
the options trader decide where to place your stops. Not every
one of these applies to every trade, but the ones that do will
give you some useful guidelines.
Perhaps the most important factor that affects stops is the
question of how much you`re willing to lose on a single trade.
My rule of thumb is that the options trader should never lose
more than 2 percent of your trading capital on any one trade.
Yet this can be tempered by other considerations, such as how
much money you have in the position. If you have a large amount
of money in a position, 2 percent may be much more than you`re
willing to lose. If so, the options trader should set stops
accordingly. However, if your account is small and you`re not
well diversified, a 2 percent stop may be so tight that you stop
out of the position almost immediately. If this is the case, the
options trader should think seriously about whether you have
enough money to trade.
Another matter to take into account is how risky you believe the
trade to be. If you think the trade is a sure winner and market
conditions are favourable, the options trader may give the
position more room to move. But if you think it`s got only a
fair chance of working out, or if the position has serious
potential to drop, set a tight stop. Also consider how volatile
the position is. If the position routinely moves up and down in
a range of 15 percent or more over the course of the day, you
can`t set tight stops. If you do, you`ll be taken out by the
position`s normal volatility. If the position is choppy and too
risky to trade without tight stops, maybe you`d better look for
a better position to trade.
If you have reason to be confident that the position will move
upward even if it swings around a bit first, it doesn`t make
sense to set a tight stop because you`ll just stop out as it
swings. However, if you think it might possibly move up but will
definitely drop if it slips below a certain price, then tight
stops are a must.
There are also a couple of basic questions to ask yourself about
the position to help the options trader decide where to place
the stops. First, is the position cheap? When a position is
inexpensive, even the smallest decimal price movement will be
fairly large in percentage terms. This means tight stops may be
knocked out more easily. It also means that if your broker has a
rule that the options trader can`t set a stop closer than .25
below the current bid, you may not be able to set a tight stop
until the price moves up. And second, what is the time frame for
the trade? On a quick day trade, tight stops are a good idea. On
a position, you expect to hold for a week or two for a trend
play, tight stops may or may not be a good idea depending on
other factors that you`re aware of.
Market conditions should always be an important part of your
decision. If the market is trending sharply upwards, tight stops
may not be necessary. If you`re trying to go long in a bearish
market, tight stops are absolutely necessary. If the market is
choppy, if it has no clear direction or if it`s full of
nervousness and fear, use tight stops, and ask yourself whether
you should be trading at all that day.
Which of these considerations is the most important? Since no
two trades are the same, different factors will dominate on
different trades. Think about all of them on every trade. If you
don`t, you`ll miss something important. Setting stops is an art.
You`ll have to experiment a bit and learn what works for you.
Occasionally the options trader may stop out of a trade too soon
and feel frustrated, but remember this is just like paying for
insurance. Sometimes you`ll be stopped out, but other times, you
will save your capital.
Over time, you`ll get better at setting stops. Eventually, you
will be able to have a sense of each trade, and set the stops
that work best for you. Then you will be a nimble and successful
options trader who can trade with any market.