Hi
These post is about stop losses. Stop losses on futures and shares seem to be quit clear, so I concentrate on Stop Losses on options.
Quote:
Originally Posted by Novice-Trader View Post
How to determine SLs for Options -
I understand different Strikes at different times of expiry react differently to the market movement.
Setting SLs in Equity or Futures seems straight forward using ATRs / support and resistance etc based on one's style.
However, the same could not be applied directly to options. I understand ATM / ITM / OTM options react differently based on the greeks and the time to expiry.
Would be of great help if someone could assist explain this.
Dear Novice-Trader
A script in advance from Larry Williams before I move on to your question. The following words have nothing to do with any stop loss. It is about Money management:
Sure, you can make money as a trader or investor, have a good time, and get some great stories to tell. But, the extrapolation of profits will not come as much from your trading and investing skills as how you manage your money.
I'm probably best known for winning the Robbins World Cup Trading Championship, turning $10,000 into $1,100,000.-- in 12 months. That was real money, real trades, and real time performance. For years people have asked for my trades to figure out how I did it. I gladly oblige them, they will learn little there - what created the gargantuan gain was not great trading ability nearly as much as the very aggressive form of money management I used. The approach was to buy more contracts when I had more equity in my account, cut back when I had less. That's what made the cool million smackers - not some great trading skill.
Ten years later my 16-year-old daughter won the same trading contest taking $10,000 to $110,000.-- (The second best performance in the 20-year history of the championship). Did she have any trading secret, any magical chart, line, and formula? No. She simply followed a decent system of trading, backed with a superior form of money management.
Now to your question about stop loss in option trading. As you say: OTM, ATM and ITM options react differently based on the greeks and the time to expiry. So far, that is right. For some now the question could emerge: Doe's an option OTM need an other stop loss system compare to an option ITM, as ITM options move quicker with the underlying as the delta is higher compare to OTM options, which have a lower delta? The answer is: No, you can use the same system.
Doe's the actual volatility in the market have an influence on any stop loss settings? Yes and no. Why? Depends on what criteria we build up our decisions we use for our stop loss, as we have different choices:
1. We can use a fixed amount of Rupees which we are willing to lose. So we buy an option with a certain prices and we know, that money is gone when market moves against us. In this case, volatility is not one of our criteria s. The amount we use for such trades can be calculated by looking at our whole trading money. If the whole trading amount is Rp 10'000.--, we can fix a % amount from that and that would be our money we are willing to lose in one trade. So, if the % is 2, we would/could spend Rp 200 for those option and leave it.
2. We again use a fix amount of money we are willing to lose. Let's say the price of the option was Rp 120. Now I am willing to lose 50 Rp on this option and that would be our stop loss. So, we place a limit order of Rp 70 (120 -50 = 70) for this option by our broker. Also here, volatility is not one of our criteria. It is a decision purely built on any amount we are willing to lose.
3 We can use a % rule on the option price for our criteria. Let us say we use a rule of 5% for our stop loss. If we had to pay Rp 120, so we would risk 6 Rp on these option trade. Now we have a fixed prices of Rp 114 and then we would sell the option. If you go for this kind of stop loss you should use volatility as a criteria. If vola is high, you have to think if you want to expand your % and risk more or if you prefer to tighten your % and risk less. This decision is also build on your risk appetite. If you are risk shy, tighten your stop loss and vice versa.
4 An other way to set a stop loss is to not fix the amount of money you are willing to lose. You can set a fixed target on the underlying and when these target is not reached in a certain time, you leave the market and sell the option with a market order. The stop loss in this case is more a mental stop loss as the time frame will be the main point in it.
5 There are more ways for a stop loss, but they are of more advanced ideas which need a good knowledge of the option greeks and advanced option analyzing software. As a simple example: You can use pure delta for stop losses. Not to recommend for any unexperienced or part time option trader.
All of the mentioned ways are done in directional option trading. You can use them under different aspects. No best or worst idea, as all of them are practicable. If you do non directional option trading, then your stop losses are given through the break even points of the upper and lower legs on your strategy analyzing picture. Example: If you implement an iron condor at once, then your break evens are given at the same time you are filled. Not necessary a stop loss to leave the market but a point on which repair strategies have to come in play.
Good trading
DanPickUp
