Stops on Options

Options can be very risky because it is possible to lose 100% of your invested capital if you are wrong.  One thing you can do to prevent this is to put stops on your options.

You can place a stop on an option in two ways.

1.       Put a Stop on the individual Option

The first thing you can do is to put a stop order on the individual option.  So, if you buy an option trading at $8 you can chose to put a stop at $4.  This way if the option ever dropped to $4 you would be out and be able to keep the remaining $4.

The major advantage to this strategy is that you will know exactly how much you can lose on an option if it turns against you.  This makes it very easy to look at your risk/reward when deciding if the option is a good buy or not.

2.       Putting a contingency order on the option

This allows you to place an order to exit the option as something else happens. For instance you can place an order to sell your option if the stock moves to a certain point.  So instead of saying “get me out if the option goes to $4” this order tells your broker “get me out if the stock goes to $45”.

The disadvantage to this is that you will not know exactly how much you will lose if the worst case scenario happens.  That does make it a little bit harder to calculate risk/reward.

However, the major benefit to this strategy is that you are still trading the stock.  Options have so many variables attached to them it isn’t possible to calculate exactly what price the option will be trading at if the stock moves down to a certain level.

But with a contingency level you don’t have to guess.

For more on stock options visit http://www.stocks-simplified.com/stock_options.html

For more on market orders visit http://www.stocks-simplified.com/stock_orders.html