Warning: Stop-Loss Orders Can Be Dangerous With This Income Strategy

Recently, I’ve received a few questions about how to manage risk when selling puts. The primary question is whether it makes sense to use stop-loss orders to exit a position if the trade moves against you.

With this in mind, I thought it would be a good idea to analyze some strategies for managing risk and explain why I NEVER use traditional stop orders for option positions.

If you’re not familiar with the put selling strategy, let me give you a quick overview:

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— A put option gives the buyer of the contract the right but not the obligation to sell 100 shares of the underlying stock to the put seller at a pre-defined price, called the strike price.

— When selling puts, you are taking on the obligation to buy the stock at the strike price if the stock drops below that level before the option expires. The income you receive for taking on this obligation is known as premium.

— The price of a put option rises when the underlying stock declines, and declines as the underlying stock rises. A put option also loses value as it approaches expiration (which benefits the put seller).

— Our strategy involves selling puts on stocks that we would be willing to purchase. If the stock remains above the strike price, we simply keep the premium as profit. If the stock trades below the strike price, we become obligated to purchase it at a discount to where it was trading at the time we sold the put option.

When selling puts, income is generated when the underlying stock remains stable or trades higher, and the put option loses value for the seller when the underlying stock trades lower. This is because a put option rises in value as stocks drop, and since we are “short” the put (that we have sold to create income), the more the put option rises in value, the greater our loss.

Many traders use a stop-loss order when selling puts. Because they are short, it is known as a buy-stop order, and it automatically buys back (or “covers”) the put option if the price rises to an unacceptable level. For instance, if we sell a put option at $2.50 and set a buy-stop order at $4.50, then we would automatically buy back our put option if the price hit $4.50, incurring a $2 loss per share.

While this approach sounds like a responsible way to manage risk, there are two big problems with it:

1. Options do not trade like stocks.

Most investment-grade stocks trade in a liquid manner with shares changing hands throughout the entire trading day. In a typical day, if a stock were to move from $51 to $53, it would hit most of the price points between those two levels. Sure, the stock may skip a few cents, but under normal circumstances, it would not jump more than that without an actual printed trade.

Option contracts, on the other hand, are notorious for gapping higher or lower. This is because although there is an “available” market for these contracts (usually there are market makers on both the bid and the ask side of the trade), the contracts may not actually print a transaction as prices move higher or lower.

This creates a significant amount of risk for us if we use stop-loss orders. In some instances, the option price could move significantly higher before a new trade is executed. By the time our stop-loss order was executed, we could be hit with a very unfavorable exit price.

2. Market makers can take advantage of stop-loss orders.

While some on Wall Street refer to market makers as swindlers and thieves, we actually need the function they provide, particularly in the options market. While I don’t agree that all market makers are out to steal your money, it is true that they operate with profit in mind, and they can make profits off your stop orders.

For instance, if an option market maker knows that there are a number of buy-stop orders in play if a put option hits $4.50, that market maker could actually execute a trade at $4.50 simply to get the stop orders to trigger, and then sell his inventory to fill the stop orders, sending the price back to a lower level.

There are a number of games that market makers can play in the relatively illiquid options market, and while I’ll stop short of accusing these traders of market manipulation, I will note that stop-loss orders in general do not fare well for option trades.

The Risk-Management Solution for Selling Puts

Rather than use an actual stop-loss order for your option positions, I would recommend setting an alert for the underlying stock. Since stocks trade with much more frequency and predictability than options, we can glean more useful information from the price action of equities.

For traders who are selling puts, the best solution would be to note the level at which a stock decline would cause you to want to exit your position. Say you have sold a put option on a stock and you would be concerned with a drop below $20.

One way to manage your risk would be to set an alert for the stock at $19.95, and if triggered, you would then buy to cover your puts. This avoids the issue of having an option contract gap through your stop price, and it also keeps your order out of the hands of market makers who might trigger your stop simply to take the other side of your trade.

Another option would be to actually have a sell-short order in place for the underlying stock, thereby selling short shares of the stock if the price hits $19.95. This would offset your obligation for the put contracts that you are short, because while you will still be obligated to buy shares at the strike price, that purchase will naturally offset your short stock exposure.

There are many ways to manage your risk when using option strategies to create income in your account. The key is to make sure that you are not exposing yourself to other unintended risks through the process of managing your initial trade.

Note: By using an income-generating put selling strategy, my colleague, Amber Hestla, helped her Income Trader members earn up to $150,000 last year. In fact, every trade she closed in 2013 — all 35 of them — was a winner. Click here if you want to get in on the action this year.