This is basically when you take an option trade and set a stop loss on the contract price itself based on your risk appetite ( a level of risk that you can comfortably take) without giving too much consideration to the movement of the underlying stock. For instance, lets say you bought the a TSLA AUG 350 Call @ 9.00 and decided that you cannot afford to lose more than 25% on this trade.
You would then set a stop loss at 6.75 which would ensure ( all things being equal) that if the Option contract declined to 6.75, it would be automatically sold and you wouldn’t lose more than 2.25 on the trade.
To set this up, you would first place the following order:
Buy To Open 1 TSLA AUG 350.00 Call @ Limit 9.00
and then once you are filled you would go ahead and place the stop order:
Sell To Close 1 TSLA AUG 350.00 Call @ Stop 6.75, Limit 6.05
A Word About “Stop Orders” vs “Limit Orders” vs “Stop Limit Orders”
I know you are probably wondering why I would use “limit orders” on the trade entry instead of “stop limit orders” like I did on the exit.
Well, Limit Orders basically tell the market maker that you want to sell your contract if/when it gets to 6.75 or better.
“Better” in this case ( since we are trying to prevent a big loss) means higher. So in other words, with the limit order you are saying “i want to sell this thing if it gets to 6.75. I will take a fill above 6.75 but I will not take a fill below 6.05”
A “Stop Order”, on the other hand, tells the market maker that you want to sell your contract at 6.75 once that price is reached.
The important thing to note is that, with a “stop order”, once the set price is reached, the order becomes executable and can be filled at whatever the current market price is, which can give you a very bad fill in a fast moving market.
Option Trading Tip #4
For instance, lets say the TSLA stock price is moving around wildly, and the Option Contracts are moving just as fast in response to high volume and volatility, and you place a stop order to get out of the AUG 350.00 Calls at 6.75. What is likely to happen here is that as soon as the price gets to 6.75 your order becomes executable.
However, if there are many orders at that price lined up before your own, there is a strong chance ( given that the market is moving fast) that your order will not be filled immediately. So a few seconds pass and you finally get filled at 5.10 because that is the current market price.
You have just lost an additional 1.65 on the contract. So, please note that even though your order becomes executable once the price is reached, it doesn’t mean that it will be filled right away. It rarely ever will be.
With a stop order you are effectively telling the market maker “I want to sell this contract once the price reaches 6.75, even if I don’t get filled immediately at that price, I just want to get out of the trade once 6.75 is hit“.
A stop order does not guarantee the best possible fill.
A stop Limit order is obviously a combination of both the limit and the stop order. With a stop limit order you are telling the market maker that ” I want to sell this contract at 6.05, and no lower, once the 6.75 level is hit.
A Simple Rule for Moving Your Stop Loss to Break-Even / Profit
But do not sell unless I can get 6.05″. The obvious downside is that you can get stuck in the trade if there is a gap situation in a very fast market, but compared to the others, it gives you more control over the fill and gives you a better chance to get a proper, cleaner fill.
Sorry about the digression. But I figured that if we were gonna talk about setting stops, we might as well clarify what they are.
Now back to the matter at hand.