Your trading plan must have an entry price, a price target, and a stop loss. In this article, we discuss how to determine stop loss for your option trades.
Managing risk
A stop loss is a price at which you decide to close your position and cut your losses. A simple way to determine a stop loss for a stock is to fix a price few points below an appropriate support level. Suppose you determine that the support level for Tata Motors is 441. You could keep 438 as your stop loss, which is far away from the current price of 510. Some traders prefer to keep tighter stops. For instance, a stop loss of 503 based on the low of the prior bar.
To ensure that the position is not stopped out because of high intra-day volatility, some traders manage their price stops on a closing basis. That is, the stop loss is not entered into the trading system. Instead, if the stock closes below 503 on any day, a trader will place an aftermarket order to sell the stock the next day. Alternatively, the trader can place the order the next day at market open.
The above process holds good for trading futures. Placing stop loss for options are, however, different. Ideally, you should determine the entry price, price target, and stop loss by reading the chart of the security you intend to trade. But this approach is difficult to apply for options trading. For one, options are wasting assets- you pay to buy a right (calls and puts). With each passing day, this right will lose value because of time decay. The time decay is a function of time to maturity and implied volatility. The latter, in turn, is a function of the demand and supply for a strike.
Therefore, the January 18000 call on the Nifty Index, for instance, cannot be meaningfully compared to the December (prior month) 18000 call. So, you cannot seamlessly combine all 18000 monthly strikes across time to read the chart. That means you will not have enough data to graph the January 18000 option and read the price pattern. For another, equity options are not liquid. The lack of liquidity leads to volatile prices. This makes it difficult to read meaningful pattern on the charts.
What should you do? If you are trading equity options, you should determine your stop loss based on the price chart of the underlying. If you are trading index options, your stop loss should be based on the price chart of related futures contract. The reason is that index futures prices reflect actual demand and supply for the contracts. Spot index, on the other hand, is just an index number.
When should you stop your options trade? Stop loss for options should be on an intra-day basis unlike the closing stops on the underlying. Suppose you buy call options on Tata Motors and determine that your stop loss is 503. You should close your long call and take losses if the stock moves below 503 intra-day.
Optional reading
When an underlying declines, a call option on the underlying will lose value not only from time decay but also because of delta. Note that delta is the change in the option price for a one-point change in the underlying. If the delta of an option is 0.60 and if the underlying declines by one point, the option price should decline by less than 0.60 point (as a positive gamma will slow down the delta).
This means the call option on Tata Motors will lose value if an underlying moves below 503 during the day. You will lose even more if you close your long call position the next day. That is why stop loss on a closing basis may not be optimal for option trading.
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