Monday, September 16, 2013

How do I determine Stop Loss

The first question I have when I started to explore into Options Trading is : How do I determine Stop Loss?  

Coming from Futures/Forex trading background, to manage my risk via Stop Loss is number one priority.  For every trade I enter, I need to know where is my Stop Loss before I open any position.  In both Futures and Forex, I have Charts for the Futures contract or the Forex pairs that you are trading.  From the Charts, I will be able to determine that the opinion of my trade (be it up or down) is no longer valid.  I need to cut loss and exit the trade.

I don't use Hard Stop, which you use a place a stop loss a fixed number of ticks/pips from your entry price.  I only use Logical Stop, where the Price Action tells me that the opinion of my trade is no longer valid.

Although Options are derivatives like Futures and derive their value from their underlying Stock/ETF, there is no Charts for Options, unlike Futures.

If I buy XYZ Dec20'13 80 Call @ $3.70, how will I know my opinion of this bullish trade is no longer valid?I cannot see from the Options Charts (there is no chart).  When the price drop to $1.70 is the trade still valid?  I also cannot use the price drop since I don't use Hard Stop.

This leaves me with no choice but to use Stock Price Based solution.

Let me use a example to illustrate.  WDR is trading at 49.13 off its support level (47.20-47.62).  I am bullish that WDR will go back to test its previous high at 55.

So, I buy WDR Dec20'13 45 Call @ 5.60.  Using Stock Price Based method, I will hold on to this Call Options contract as long as WDR stay above the support level 47.20.  If WDR fell below 47, I will exit this trade.  Using Options Calculator, assuming all other variables remains constant, the theoretical Options price is about 4.20 when WDR Stock price is 47.00.  I will exit this trade with a potential loss of $140 (5.60-4.20 * 100).

This Stock Price Based method seems ok for now.  It provides me a method to cut loss and exit my Options trade when the trade is no longer favourable/valid.  However, I am also aware of some complications.  Option price may change even when Stock Price remains the same.

Besides Stock price, Option price can change due to other variables such as Volatility and Time Decay.  As volatility increases, option premiums increase; as volatility decreases, option premiums decrease.

For example, assume we purchased XYZ Dec20'13 80 Call @ 3.70 when XYZ was trading at $82.00 per share yesterday.  Today, it is a quiet market, XYZ traded in a narrow range of $2 ($81.50 to $83.50), compare with a typical range of $10.  It close unchanged at $82.00.  However, our Option is trading for $2.70, a drop of $1.00.  The decrease in implied volatility cause the option price to drop $1.00.

I do not have a solution for these complications yet.  If you know of any, please share with me.  Thanks.

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