Options trading and stop loss order

I have been reading about options and futures trading in the last week and I think I understand both of them. I have also been reading about using stop loss order so I have a question in relation to that.

Options gives a buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date. However, the buyer has to pay a premium for that rights and the premium is the only risk to the buyer. I also understand a call option (buy it if you think the price will increase) and put option (buy it if you think the price will decrease).

An example given on one of the websites is assume for a moment that it is April 5th, and you are following XYZ, which is presently at $29 a share. You think that this stock will go up in price in the next month and a half or so, to well past $30 a share. Knowing about options, you choose to buy an XYZ May 30th call option for $2, instead of buying the stock outright. This option gives you the right to buy 100 shares of XYZ Stock at $30 a share any time before May expiration NOTE: For this right, you pay $200. (Remember, all prices need to be multiplied by 100, since all options are usually for 100 shares). On May 30th, assume XYZ is at $35 per share. You have a call option, which can be exercised to purchase 100 shares of XYZ Stock at $30 per share. If you do that, you can then sell that stock back in the market and make a $5 return per share, or $500. Since your initial call option premium was $200, your net profit is $300. If you had been wrong about XYZ and it had gone down to $25 a share, your only loss would be the premium amount you paid for the call option, $200 ($2 per share), since the option would be worthless.

My question, based on the example above, is how does one set a stop loss order for options trading? My understanding of stop loss order is that it is used to prevent losses beyond a certain set point. If I had bought the call option and if the price goes up, I make the $300 profit after deducting the premium, but if the price goes down, can I use a stop loss order to make a lesser loss than $200 for the premium that I have already paid?

If the stop loss order can be set for options trading, please give me an example.

Thank you.

Ken

kenviro said:

. . .
My question, based on the example above, is how does one set a stop loss order for options trading? . . .
If the stop loss order can be set for options trading, please give me an example.

Click to expand...

You can't. No such thing. Doesn't exists.

I do some intraday option activity. With normal methods a stop-loss on options is not comfortably feasible for various reasons:

- the value of the option is linked to the value of the underlying by a law which is not linear. You might use the value of the "delta" and more or less try to infer which could be the value of the option if the underlying goes down of a certain amount. But delta varies (you also have a "gamma" value which describes how fast the delta varies). You can see delta and gamma described in every "primer" regarding options.

- Once you have devised where more or less you would put your stop-loss in terms of value of the option (which you have calculated based on where you would put your stop-loss if you had bought the underlying instrument) you have another problem, i.e. the last transaction can remain static when the values on the book change.
So you have, e.g.
LAST BID ASK
4.00 4.00 4.05
4.00 3.95 4.05
4.00 3.95 4.00
4.00 3.90 4.95
4.00 3.85 4.95
4.00 3.80 4.90
4.00 3.85 4.90
4.00 3.75 4.85

etc.
You get the point. You wanted to sell at 3.75 but you see that when the bid reaches 3.75 the spread can be very high, and also the last price is still 4.00 so your stop-loss is not "triggered".

So you would need a triggering system based on "order book values" (bid/ask) rather than "last price", and you should also try not to be caught with a market order in a situation with a high spread.

My opinion is that option trading is not easily done with stop-loss.

Hope this helps
Incerto