You probably know that Put options can be used as an insurance policy on a stock position. Buying a Put option gives you the right to sell your stock position at a fixed price, no matter how low the market price of the stock may drop. But a stop-loss order also will get you out of a stock position if and when the stock’s price drops below your designated stop-loss price.
What are the pros and cons of using puts vs. stop-loss orders?
First, let’s examine the way a stop-loss order works. To use one, you place an order to sell your stock if its price drops below a certain level. There are two possible order types used – the Stop Market order, and the Stop Limit order.
Stop market order
The Stop Market order is triggered when there are one or more trades at or below your stop-loss price. When that happens, an order is released to the exchange to sell your stock at market. This means that the order is to sell the stock at whatever price other investors, traders or market makers are willing to pay at that time for the stock. It is possible that your order may have significant slippage, which means that the price of the stock could fall much further than your stop-loss price before your order is filled. Your order will be in line behind all other market orders that were sent before yours was. In normal markets and with widely-traded stocks, slippage is not much of an issue. But in the type of market where you really need to dump your position, many other people will be doing the same.
For example, let’s say you had a position consisting of 100 shares of SPY, worth about $29,000 at today’s prices. You place a stop-loss order, let’s say, 10% below the current price, at 261. I’m using 10% just as a convenient round-number example. You could, of course, place your stop-loss at any lower price you want.
The market drops hard on some sort of terrible news. A trade is printed at $261.00 and your order is triggered. In the best case your Stop Market order will be filled at a price just a few cents below $261.00. But it might not. It could be that at that time there are no buyers willing to pay anything near $261.00. Your order might be filled at $258, or even lower. In a really bad scenario, the bad news might come while the markets are closed. When they open, the price of SPY might be much lower. In that case, your stop market order might be executed at a dramatically lower price.
Stop limit order
The other type of stop-loss order, called a Stop Limit order, doesn’t avoid the problem of gaps – in fact, it may give a worse outcome. With a stop-limit order, you specify a stop-loss price to act as a trigger, as in the Stop Market order. But when that trigger occurs, the order that is sent is not a market order to sell, but a limit order to sell at or above a specific limit price.
For example, one could set a Stop Limit order with a Stop price of $261.00 and a Limit price of $260.00. If triggered by a trade crossing the tape at or below $261, a Limit order to sell at no less than $260.00 would be sent. The problem here is that no one is required to buy from you at $260.00. And no one will if the price of SPY has gapped down to a price lower than that. What could happen is that the order will be triggered and simply not be filled, as SPY continues to drop – in effect you have no stop-loss at all. So, Stop Limit orders are not a good choice as protective (stop-loss) orders.
The good thing about stop-loss orders is that there is no charge to place them.
Now let’s compare the use of a Put option as protection.
At this writing, SPY was at $289.33 per share, or $28,933 for 100 shares. A Put on SPY at the 265 strike that expired in six months was available for $491. To buy that put, we would need to pay $491 in cash. We would then be guaranteed that we could sell the SPY stock at any time in the next six months for no less than $265 per share, or $26,500 for the 100 shares. In that worst-case scenario, the total drop in our net worth would be the decrease in value of the SPY shares of $2433 [$28,933 – $26,500], plus the cost of the put [$491]. So worst case, our loss from here would be $2,433 + $491 = $2,922. This is just about exactly 10% of the current value of $28,933. And it could not possibly be any worse than this, even if SPY should drop by 50%, as it did in 2000 and again in 2007.
Stop loss order vs. put option
So, here is the comparison of the puts vs. the stop-loss order (I’m comparing a stop-market order since using a stop-limit order for protection is never recommended for the reasons described above):
The stop-market order placed 10% below the current price:
Will almost always work as expected and liquidate your position at or near the specified stop-loss price. In that case, your loss would be around 10%, about $2,893.
Is not guaranteed to work as expected. In fact, your loss could be far greater and have no actual cap.
The put option with a strike price a bit less than 10% below the current price:
Costs money. In this case, $491, which is 1.7% of the current value for six months’ worth of protection.
Has a maximum loss that is about the same as the 10% stop-loss order. (10% was chosen somewhat arbitrarily here. Varying levels of protection can be purchased by selecting puts at other strike prices. The more protection they provide, the more expensive the puts are.)
Puts a floor under your portfolio such that your loss can never be more than that maximum loss, no matter how far the market drops and even if that drop comes in the form of a massive gap that would make a stop-loss ineffective.
So there you have it, stop-loss orders can limit your losses, but possibly not as much as you planned, at no cost. Put options can insure your portfolio absolutely, but at a cost. Which is preferable is a personal decision, and the decision you make should be an informed one.
The use of options is not limited just to insurance. Options can do much more. There are other strategies that you can use to generate short-term income, from mild to wild in terms of leverage. When done properly, option trading can be very profitable. For more information, contact your local center about our Professional Options program.
Read the original article here - Using Puts vs Stop-loss Orders to Protect Stock Positions