Mike’s note: Happy Holidays from Jeff and the team. Since our offices will be closed from now until January, we’re sending you a series of Jeff’s best-ever essays.
Read on for a popular mailbag issue where Jeff answered a common question he often gets on stop-loss orders…
Once again, it’s time to open up the mailbag and see what’s on readers’ minds. In today’s Mailbag Friday issue, Jeff answers a very common question we receive often, and a reader wants to know… does Jeff let the news dictate his trades?
Read on…
Should I have stop (loss) orders on all of my options trades? How long should I wait after getting into a trade before I put a stop (loss) order on it?
– Brian
That’s a great question, Brian. Stop orders are designed to protect a profit or limit a loss. When trading stocks, it’s important to use stop orders to limit your downside risk so that one bad trade doesn’t blow up your account. When buying speculative call and put options, however, it’s different.
You see, the most you can lose when buying an option is the premium you spend on it. So, your potential loss is already limited to a small fraction of the stock price. As long as you exercise proper position sizing and don’t take on an option trade that is far larger than appropriate for your account, then you don’t need a stop-loss strategy when buying options.
Yes… you do need to be willing to lose 100% of the premium you spend on puts and calls. But losing 100% of a $1 or $2 option premium is far better than losing 10% or 20% of a $50 stock.
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Once an option trade is profitable, however, then it makes sense to set a stop-loss price. As a trader, the worst feeling I get is when I’m watching a profitable trade turn into a loser. Don’t let that happen.
As a general rule, once an option position is up 50% or so, I’ll set a stop at my breakeven price. Then I’ll keep raising the stop as the trade continues to move in my favor. This way, I’m ensuring a profitable trade.
Finally, I almost NEVER enter stop-loss orders – on stocks or options – with my broker. There’s just too much potential for “monkey business” if an options market maker looks at a quote screen and sees thousands of option contracts (from my subscribers) with stop-loss orders at the same price, and within range of being hit.
It’s better to keep your stop-loss as a mental note. Watch the position. And, if the price hits your stop, then enter an order to exit
the trade.
Of course, if you can’t watch the position constantly during the trading day, then your only alternative may be to enter your stop order with your broker. Or set your stop based on a closing price. Then you can exit the next day.
Jeff, I have followed you for several years now and have learned so much on how to be patient with the market. I know you look at technical indicators most of the time. Do you pay attention to how culture affects companies?
For example, Target has suffered for some of the social positions they have taken and this to some extent has affected their stock price. Just curious what your thought process is and thanks for your efforts to explain how the market works.
– Dave
Hi Dave. Thanks for your question. One of the main benefits of technical analysis is that you can look at a chart of a stock (like Target) and see investor psychology, sentiment, and reaction to cultural events already worked into the stock’s price.
The chart is simply a snapshot of how investors feel about the stock at that moment in time. If those factors create extreme conditions in the chart – like overbought or oversold conditions – then it could set up well for a possible trade.
So, to the extent that a cultural event will create an emotional reaction in a stock’s price then yes, I do pay attention to it. And, I will often trade off of it.
Best regards and good trading,
Jeff Clark
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