Should You Use Stops?

A “stop loss” is exactly what it sounds like; it’s a “good ‘til canceled” order which dictates an exit from your position if it’s reached your maximum risk limit. Seems like a reasonable thing to use, yes? 
 
Well, yes and no. And I suppose “it depends” as well. 
 
There are some applications of using Stop Loss orders that are non-negotiable. Futures trading is a great example of a non-negotiable use of stops. 
 
Typically when you are trading futures contracts in a directional manner, you will use a “bracket order” which defines your “take profit” exits as well as your “stop loss” exits. Done correctly, it’s a simple, linear relationship which allows you to define your maximum trade risk before entry. They are “set it and forget it” simple. 
 
So far, so good. Futures contracts don’t have any variability to them (like implied volatility) thus they are the perfect linear trading instrument. 
 
Where we get into complications is when we’re trading options, and especially spreads. It’s not hard to set up a “take profit” limit order to close down your trade when the result is positive. In fact, we recommend using them. Where it all goes awry is when we try to dictate a “stop loss” exit using options. 
 
I certainly found this out the hard way many years ago when I just casually added some “max debit” stop orders on some credit spread positions. I was horrified to see that they filled for max debit with the price of the index HUNDREDS of points away! There was no way that they should have filled, but they did. 
 
Remember that a stop order is a “MARKET” order and the “market” for an option or a spread can vary by an unbelievable amount depending on what is happening in that exact second in the market. And also understand that each option is its own little “micro-market” with supply and demand constraints, and a bid/ask spread which can move an unbelievable amount. 
 
If you decide to use stop market orders on your credit spreads, it’s only a matter of time before you too will endure a “rite of passage” and be stopped out prematurely on a trade, possibly at a much greater debit than you expected. 
 
So what is the answer? There are three different ways that you can solve this dilemma: Mental Stops, Conditional/Stop Limits, and Trade Structure. 
 
Mental Stops are exactly what they sound like; YOU make the decision when to exit, based on whatever criteria that you pre-determined at the onset of the trade. This requires TIME and ACCESS to be effective. As an example, I sell naked puts on the Micro Emini S&P500 futures contract on TastyTrade. They do not allow me to set a stop loss order, although they do allow me to set a profit-target limit order. I just have to keep tabs on the desired max debit limit, and execute an exit if it hits that level. It’s a bit of a challenge with an instrument that trades 24 x 5, but one that I’m willing to undertake. 
 
For those of you using spreads, you can consider a STOP/LIMIT order if you broker allows it. You will define the STOP price at which the online broker is triggered into a “stop” condition, where it then passes the ability to exit the trade into a LIMIT order. The STOP fires, and then the broker will close down the trade at NO MORE than the LIMIT order specifies. This prevents an inflated exit, however there is the risk that you might not exit at all if IV spikes and exits immediately inflate. These types of exits are necessary for traders who might have primary responsibilities OTHER than trading during the day, like a stay at home Mom or an office worker. 
 
My favorite solution is Trade Structure to enact risk management. Set the reward-to-risk of the trade such that even a full loss is within your limits, and let the price do what it will. No stop required. 
 
Whatever solution that you choose, remember the First Rule of Risk Management: set your exit BEFORE you enter the position, not after. 
 
In your corner……..Doc Severson

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