Set Your Stop loss With an Option!

Stop Sign On a percentage basis, this May was the worst-performing month since 1962. Volatility really began to pick up around April 27 and exploded on May 6, with the so-called “flash crash.” Many long side investors were “stopped out” that day, possibly at prices that were far below where their actual stop loss orders were, due to the speed at which the market moved.

The S&P 500 Index’s high this year (hit in late April) was 1,219; this is a level the index had not seen since September 2008. While the past year has been good for the S&P, what took months to gain was given back in about 40 days (and for some, in a single day).

A friend of mine, Alan Knuckman, was on CNBC on Friday making the point that traders and investors could use options as a stop loss. Melissa Lee, who agreed that options can be used in this manner, has spent the past year as host of “Options Action” and “Fast Money” on CNBC. Perhaps she has developed not only a knowledge of options, but perhaps a reverence for the derivative. Alan and Melissa do not represent the majority, as options knowledge still remains relatively specialized. The space is growing, however, and education, trading tools, and options volume in general is proliferating.

But for many investors, options – with their foreign nomenclature and seemingly odd behavior and risky reputation – are still not utilized in most accounts. Part of my goal of this column is to unravel some of the mystery surrounding options trading.

One of the most basic options strategies is the long put, which is the purchase of a put option. A put gives its buyer the right to SELL 100 shares of the “underlying” stock, on or before the option’s expiration date. Put options can be bought alongside a long stock position, giving the owner of the put the right to sell their existing shares. The put option, unlike a stop-loss order may also offer a hedge against a catastrophic loss in the event of a gap lower. The downside is that you have to pay for that hedge.

Let me explain…

Let’s assume you bought 100 shares of Johnson & Johnson JNJ for $65.00 back on April 8, with the intention of holding it for a couple months. Let’s also assume, for example, that you bought one July 62.50 put on that day for $1.00 per contract.

Because you are long the put, you have the right to sell the stock at $62.50, no matter how low the stock goes, as long as you own the put. So in theory, you have capped your risk at $2.50 ($65 for the cost of the stock minus the $62.50 put strike). You can’t forget, however, the $1.00 you paid for that put, which increases your total risk in the trade to $3.50.

This risk would be similar to you placing a stop loss at $61.50, which is $3.50 lower than where you own the stock. This stop loss order may NOT guard you against a gap lower in the stock or an extremely quick downside move. On May 6, JNJ had a trading range of roughly $5.00, from $65 to $60; it ended up closing at $63.40 that day. If you were long stock with a stop-loss order at $61.50, your order would have been activated and who knows where it would have been executed due to the high volatility on the day. Let’s assume that you were sold out at $61.25; you would have realized a $3.75 loss.

If you were long that July put against your long stock, however, at the end of May 6 you would have an UN-realized loss of $1.60 and still be long your stock and your put. That put, due to the drop in the stock and the subsequent rise in volatility, may have been trading at $2.00 or more, which could have offset your loss even further.

When JNJ was at $60.00 (a five dollar loss in the stock), that put would have had to have been trading for at least $2.50, which is its parity (or intrinsic) value, but most likely much more. You could have potentially sold that put for a profit if you believed the stock was going to recover or continued to hold the put as a downside hedge. The put’s value will change according to its delta and other Greeks, even if the stock itself is gapping up or down.

Today, JNJ is trading at $58.90, and the July 62.50 put is worth $4.00. Certainly, JNJ could have continued to rise, which might mean that your put expires worthless and you could potentially lose the $1.00 premium you paid. Another point about this strategy is that the price you pay for a “protective” or “married” put, as they are called, will increase your cost basis in the stock. So if you purchased JNJ at $65.00 and bought the July 62.50 put for $1.00, your cost basis would be $66, potentially requiring the stock to move higher for you to break even.

Be sure to paper-trade all new strategies to ensure you fully understand them before trying anything with real money.

Photo Credit: thecrazyfilmgirl

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