Using Options In Place of Stop Losses

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Successful trading requires the ability to identify markets that are about to move in a direction that can be forecast and the ability to adapt to market conditions once trades are active and open. This becomes even more true when market conditions move against a trade, as this is when the real financial risks become apparent.

Of course, there is a wide variety of trading strategies and techniques that are available for use when these conditions are seen and decisions must be made. When looking at the conventional wisdom espoused in forex tutorials, the typical methods of risk management usually recommend the use of stop losses as the best way to protect a trade from accumulating unnecessary losses.

And while this is a perfectly acceptable approach, it should be understood by those active in the forex markets that this is not the only method available and that there are other techniques that will be better suited for different market environment and trading scenarios. In fact, some of the problems that traders might encounter with the use of stop losses can be rectified and overcome with the use of options, which is an aspect of trading that is often neglected by those more familiar with traditional spot trading.

Disadvantages and Potential Limitations When Using Stop Losses

Conventional trading wisdom shows that excessive losses can be avoided when stops are used as part of a pre-structured trade. If market prices reach a point that we initially found to be unlikely, a stop loss will trigger, the trade will be closed and additional losses can be prevented.

But the fact is that a stop loss is really more like a tourniquet that is used to stop the bleeding. And while this tourniquet is able to prevent further damage and keep the body alive, there is not much flexibility in the ways this job is done or in how or when the bleeding is actually stopped. Essentially, once a placed stop becomes active as a market order, there are a few different outcomes that can actually unfold.

The flaws that do exist when using stop losses become apparent when they are unable to protect traders from unexpected losses. Unfortunately, these situations tend to occur at times when traders need to most protection (such as in highly volatile and fast moving markets) but this can also occur during times of major shifts in supply and demand or in consolidating markets, as stop losses can pigeonhole traders, forcing them close trades under less than optimal conditions.

In essence, the usage of stop losses is in reality a one size fits all trading solution,and it should always be remembered that this isn’t the only choice that is available to traders. In fact,the use of options can allow traders to ease out of their trades in different ways, change time frames for your position, or to reverse trading exposure without opening up your account to additional risk (relative to what would be seen with the use of stop losses).

Looking for Alternative Solutions

When looking for alternate solutions, forex traders can compare the relative values of options and stop losses, there are some properties that characterize options which make them a favorable choice as traders look to protect their open positions. Here, we will look at some of the ways traders can use options during market conditions that are more volatile and quickly moving to see how this approach can stand up to the more traditional methods that are commonly used.

The first problem that can be encountered when using a stop loss during volatile market periods comes when trading with brokers that do not guarantee stop loss prices. So, in essence, there is always the possibility that the market could gap right over your stop loss and create larger losses than you were expecting. To be sure, there is always the chance that this type of occurrence can be seen, especially given the fact that stop losses are generally set in price areas the market is unlikely to reach.

It is not surprising to see enhanced volatility during periods like these and when there is greater volatility, there is a larger potential for price gaps in critical areas. This is also referred to as “slippage” and is seen when your stop order is filled at a price worse than your original order. In some cases (such as when leverage is maximized) this can create losses that are massive when looking at your account in percentage terms.

But when options are used, there is a much greater level of certainty during volatile conditions, as your original orders must be executed at their originally agreed price. An example of this could be seen if a trader were to buy the EUR/USD at 1.3050, with a stop loss at 1.2975. When using options traders could simply enter into a CALL option, using a strike price of 1.2975 as a way of guaranteeing you will not be long the EUR/USD at any price below 1.2975.

Trading Benefits When Using Options

While it is true that you must pay for the option in the example above, there are two additional positives that can be gleaned from this approach. First, buying “out of the money” options generally cost less relative to “in the money” options. Cheaper options can also be found when using options that run counter to the prevailing market trend, as these have lower volatility levels. Second, the use of options is the easiest way to manage potential losses by controlling slippage. For this reason, this approach is also referred to as having a “hard stop.”

Trading in Consolidating Markets

Managing stops can also become difficult during consolidating markets, which might be surprising to some. Since markets cannot move straight up or down, there will always be pullbacks and traders must make an assessment of whether markets are consolidating or truly changing direction. But, in both cases, stops will react the same way in both scenarios (consolidation or reversal), and once triggered, will close a trade at a loss.
There is, essentially, nothing you can do if the market hits your stop, stalls, and then whipsaws as it moves back in your initially favorable direction. For these reasons, stop losses are basically all or nothing mechanisms, which leave very little room for error when whipsaw conditions are seen. Here, there is always the possibility that you can have the market direction correct, and ultimately be forced to encounter losses.

A Solution with Options in Stop Loss Areas

Luckily, options can offer the opposite effect. When placing options in areas otherwise designated for stop losses, you will have the chance to hold on to a position that would have been stopped out in the spot markets. While the Delta of these options present some additional complications, these options can balance some or all of the trading losses as the values increase. This approach gives traders extra room when it is unclear if the market is consolidating or truly reversing, even while holding both a spot and options position.

So when fundamental shifts in the market are approached with an additional options trade (in lieu of a stop loss), unfavorable outcomes can be diminished in two ways. Traders gain additional protection from extreme moves that create losses when spot trading alone, because the option will change in value at the same rate. Additionally, if the market change is not large enough to trigger limit moves, but is still moving in an unfavorable direction, you can “leg out” of the trade as a protective solution. Here, you exit the spot trade and keep the successful options trade open. In this way, the disruptions of negative can be mitigated.

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2012-11-27 11:23:30

Source: http://www.traderslaboratory.com/forums/showthread.php?t=14745&goto=newpost