Previously in this column, we discussed how to apply stop-loss on option positions. We recently received a reader query on whether it would be optimal to use stop-loss for options on a closing basis like transactions in the spot (cash) market. By closing basis, we mean that you stop your position the next day if the underlying closes below your stop-loss level the previous day. Accordingly, this week we discuss why stop-loss on option positions should not be on a closing basis.
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Your stop-loss on equity options should be based on the underlying price. Why? You buy an option instead of the underlying because options require lower trading capital. Therefore, the objective of buying calls is to bet on the underlying moving up. In addition, you can benefit from volatility explosion by betting on an option’s vega.
Also read: Mastering Derivatives: Gamma effect of day-trading options
Logically then, if the underlying declines, you should close your call position and cut your losses. Suppose you buy the 2480 May call on Reliance Industries. You may want to close your long call position and take losses if the stock declines to, say, 2445.
Stop-loss on index options should be based on index futures rather than on the spot index. The reason is that index futures are tradable whereas spot index is not. It is more meaningful to gauge sentiment of market participants based on actual demand driving contract prices as in the case of futures.
Now, the stop-loss must be on an intra-day basis, not on a closing basis. Why? Options are wasting assets, shedding value with each passing day because of time decay. This means taking stop-loss on a closing basis could lead to more losses. That is not all. When an underlying declines, the call price falls, driven by its delta.
Also read: Mastering Derivatives: Trading mispriced volatility
So, your long call position will lose because of delta and theta when the underlying declines, whereas it will move up because of delta when the underlying moves up; gamma helps long position whether an underlying moves up or down, but the size of an option gamma is small. Therefore, given the size of delta and theta, the unrealised losses on your options could be large. Besides, with theta always hurting the long position, it is moot if the option price can recover the unrealised losses if the underlying moves up the next day or thereafter — another reason why stop-loss on a closing basis may not be optimal.
Optional reading
Stop-loss on a closing basis works for an underlying because the position does not suffer from time decay. True, there is an opportunity cost of holding a loss-making position. Also, you may be forced to sell the underlying at a lower price the next day if the price gaps down. But that is the risk you should take to avoid missing on a profit opportunity when the price rebounds after a sharp intra-day decline.
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