Why You Should Never Use a Stop Loss in Options Trading

Furthermore, combining multiple options and creating a spread enables traders to express a number of views that would be impossible using stocks or futures.

But the flexibility and dynamic nature of options bring with them some drawbacks.

Primarily, you can’t trade options in the same fashion as an S&P 500 futures contract. Whereas you can quickly trade in and out of several futures contracts in seconds due to their deep liquidity and narrow spreads, you can't in the options market.
 

Options Are Illiquid

Upon opening an options chain for a highly liquid underlying like Apple or an S&P 500 ETF, you're greeted with several different expirations, each sometimes containing dozens of contracts for different strike prices.

With over a hundred contracts existing for a given underlying at any time, you'd be correct in assuming that some are illiquid and thinly traded.

While the near-the-money strikes in the closest few expirations typically have adequate liquidity, it becomes a significant problem as you look further out-of-the-money or longer-dated options.

There are just too many options for them to have the liquidity of a stock or future.

Spreads Create Complications

When trading spreads, as most experienced traders do, you're already doing something counterintuitive, trading multiple different securities simultaneously in one go.

Take a simple Bull Call Spread--we buy a .30 delta call and sell another .15 delta call to reduce the premium outlay.

Say we buy this spread for $1.75:

●     The .30 delta call costs $3.00

●     We collect $1.25 in premium for selling the .15 delta call.

The .30 delta call is closer to the money and hence is more liquid and will have narrower spreads compared to the .15 delta call. And because our .30 delta call has a higher gamma and delta, it will fluctuate more in price.

So if you want to exit the call spread, you might not be able to get an excellent price when you try to trade it as a spread. But if you're "legging out" of the trade or closing out each contract individually, you're forced to try to exit the illiquid option first, so you don't get caught short an illiquid option after you sell the more liquid .30 delta option.
 

Wide Bid/Ask Spreads

As a result of the massive number of unique option contracts that exist at a given time, many of them are relatively illiquid, especially when compared to stocks and futures.

It's common for an option to have a bid/ask spread that exceeds 10% of the total price. This is a remarkable contrast to a Dow 30 stock, which could cost $200 and have a spread of one penny.

As a result of these massive spreads, options traders need to "work" their orders more. They'll often use the midpoint of the bid/ask spread as their reference price and try to get filled as close to the midpoint as possible. However, if you need to trade now and nobody will trade with you, traders are sometimes forced to take liquidity from the bid or offer.

So you can imagine that using a stop order, which triggers a transaction as soon as one price is touched, can result in unintentional bad fills.

A standard stop order becomes a market order once a given price is hit. If the spread is wide, you're taking a massive haircut. The other option is, of course, using a stop-limit order. But we're left with the same issue. Options are pretty illiquid, meaning your order might go unfilled, and the price might move away from your order before it gets filled.

Having a stop-limit order sitting in the market can give you a false sense of confidence, and feeling protected. However, if the order goes unfilled, the position can go significantly against you before you notice what occurred.

Options Positions Can Evolve in Unexpected Ways

We all understand that an option's Greeks do a pretty good job explaining the factors affecting its value. However, the Options Greeks aren't static. They evolve just as time, price, and volatility do.

As a result, you need to be an options veteran to have an intuitive understanding of how your options position will evolve given a drastic enough change in a given factor.

For example, if volatility just dramatically increased but only managed to whipsaw price, leaving it relatively unchanged, your new options position will behave differently moving forward. If you have a stop loss in the market, the stop loss might trigger due to the change in option characteristics, even if you still like the position.
 

Alternative to the Traditional Stop Loss

Using Price Alerts

If you use the underlying price to dictate your options trading, a potentially superior alternative to using pure stop losses is to set your discretionary stop losses using price alerts.

This involves setting price alerts for an underlying price that would drive you to trade and use the alert as a signal to start working an options order.

For instance, perhaps I own a few AAPL 142 calls, and I want to sell half of my position if AAPL hits 146. I can go into my charting software (TradingView) and set an alert for $146. As soon as the alert hits, I can start working a sell order for half of my calls, trying to get filled at the midpoint.

This approach gives you far more flexibility. Using the previous example, we might see that AAPL trades through $146 with considerable upside momentum. In this case, I may hold on for a bit longer until the market slows down to maximize profits. We would lose out on this opportunity if we had a stop loss in the market.

Using Stop-Limit Orders That Trigger Based on the Underlying Price

This approach allows us to combine the use of price alerts and the automatic nature of a stop order.

We set the price alert at our ideal exit price, but we also tell our trading platform to automatically send a limit order at a given reference price, like the midpoint of the bid/ask spread.

Instead of using the price of the actual option contract or spread to dictate where we exit the trade, it’s generally preferable to use the underlying stock price instead.

For instance, if we owned AAPL 142 calls, instead of setting an order to sell when the calls are trading at $1.00, it’s probably preferable to use something more concrete, like AAPL stock trading below 139.

So in English, "sell 3 of my AAPL 142 calls at the midpoint price if AAPL stock trades below 139." This would require you to use a stop-limit order, which carries no guarantee of execution.

While most modern options trading platforms are capable of a simple conditional order that allows you to sell an option when an underlying reaches a certain price, some platforms might not let you to do this, potentially forcing you to adapt or switch brokers.
 

Bottom Line

Mechanically entering and exiting options trades is much more complex than stocks or futures. There are too many factors, namely wide bid/ask spreads, to consider.

As an options trader, it's typically better to start slow. This often means focusing on the 15-45-day expirations reasonably close to the money. Enter trades that give you time to exit when you decide you're right or wrong.