Protective Puts Vs Stop Orders

Protective puts and stop orders both allow you to limit your loss in the stock market.  Each has its own advantages and disadvantages.

So say we bought the stock at $54 and want to limit our losses to $4. We could do this by buying the $50 put for $8.  Now if the stock goes down the most we could lose is the difference between $54 and $50 or $4.  The advantages of doing it this way are.

1.       Gaping down

If the stock gaps down and opens at say $48 we would still be able to sell it at $50.  Gaps don’t affect this strategy.

2.       Stops you from getting stopped out too early

If the stock has a bad couple of days and falls down to $49, then it picks it up and goes up to $70 you were still in the trade.  If you would have put a stop order however you would have been stopped out when it pulled back and missed the rally.

The other way for limiting your losses is to simply place a stop order on it, telling your broker if the stock gets to a certain level get me out of it for a small loss.  The advantages to this are.

1.       You don’t have to pay

You don’t have to pay anything to place this order other then the commissions you would have to pay if you get stopped out.  Sometimes buying insurance on a stock just isn’t reasonable.  In this case you can place a stop order.

2.       Let’s you exit the trade quickly

This allows you to exit a trade quickly and move onto the next trade.  In some cases it is just a better idea to get rid of losers faster and put that money to better use somewhere else.  There is nothing wrong with waiting for your stock to come back if you have a protective put to limit your losses, but sometimes waiting for it to come back will make you miss bigger profits elsewhere.

For more on protective puts visit http://www.stocks-simplified.com/protective_put.html