It’s almost always better to lose 100% on an option trade than it is to lose 20% on a stock.
Granted, it’s never fun to lose money. But, it is an inevitable part of trading. So, traders should utilize strategies that are designed to reduce risk and to keep losses small.
Many traders do this by using a stop-loss discipline. They determine, ahead of time, the maximum amount they’re willing to lose on a trade. If a stock falls below that level, they exit the position. No questions asked.
For many traders, that amount is 20%. So, if they buy a stock for $10 per share and it drops below $8, they get out of the trade. It’s a 20% loss. It hurts. But, it’s not devastating, and it’s not going to blow up their accounts.
By using options, though, traders can reduce that loss…
Let me explain how by using an example of an option trade that expired worthless on Friday. My Delta Report subscribers lost 100% on the option position. But, it was far better than the loss they would have suffered in the stock.
In mid-November, it looked to me like the price of oil was setting up for a bounce. Oil had fallen from $75 per barrel to $55 in about six weeks. That was a quick, 26% decline. The action created oversold conditions. And it set up an interesting, speculative trade.
So, I recommended that aggressive traders could buy a speculative call option on USO – the exchange-traded fund that tracks the price of oil.
At the time, USO was trading for $12 per share. Traders could buy the stock for $12, and then set a stop-loss at $9.60 to limit any damage to “just” 20%. That loss would have been triggered last Friday when USO traded down to $9.55.
Someone who normally trades 1,000 shares at a time would have suffered a $2,400 loss. That hurts. But, it’s not going to wipe out your account. You can take the loss and move on to another trade opportunity.
Active traders, though, should always look to the options market for ways to minimize the risks of a stock trade.
Using the USO trade as an example, a trader who was willing to risk $2,400 on a 1,000 share purchase of USO, could have taken that $2,400 over to the options market and worked out a better deal.
At the time of my recommendation, the USO December $12 calls were trading for $0.66. Rather than buying 1,000 shares of USO at $12, I recommended buying the USO December $12 calls for $0.66.
So, for $660 (the price of 10 call options, which give the buyer the right to buy 1,000 shares) a trader can have nearly the same exposure to USO as buying 1,000 shares for $12,000. Instead of putting up $12,000 and risking $2,400 with a stop-loss instruction, an option trader can take nearly the same position and risk just $660.
Super aggressive traders can use options to create even larger positions while still limiting their loss exposure to something less than what they’d have on the stock. For example, traders could have doubled their exposure to USO by buying 20 call options for $1,320. And they’d still be risking less than if they had bought the stock and kept a 20% stop-loss.
My point is… If you recognize what you’re willing to lose on the stock, and you take only a portion of that amount and buy call options instead, then you can keep the same sort of upside potential on the trade while limiting the downside risk.
The USO trade didn’t work out. The December call options expired worthless. My subscribers lost 100% of their $0.66 call option position.
But, losing 100% on a $0.66 option is a far better result than losing 20% on a $12 stock.
Consider this added benefit as well…
We were willing to risk $2,400 on a 1,000-share purchase of USO. We bought the USO call options and lost $660 instead. So, we still have $1,740 of the funds we were willing to risk on the stock. If we still like the potential of the trade, we can go back into the option market and put some of that money to work on another call option.
Of course, it hurts to lose 100% on an option trade. But, as long as you limit your option purchase to an amount less than what you were willing to lose on the stock, then buying the option is a better trade.
Aggressive traders who bought 10 USO call options, based on my recommendation last month, suffered a $660 loss. I hate that it happened. Nobody wants to record a 100% loss on a trade right before Christmas.
But, the result is far, far better than losing 20% on the stock.
Losses are going to happen. But, if you use options the right way, then you can minimize the impact of a loss to something far less than you would experience with the stock.
Of course, it always looks better in one’s track record to report a 20% loss on a stock versus a 100% loss on an option position. But, in terms of real dollars at risk, I’d rather suffer a 100% loss on a $0.66 option than a 20% loss on a $12 stock.
Best regards and good trading,
Jeff Clark
P.S. In a market environment like we’ve seen this past couple weeks – and the one I see coming in 2019 – strategies like these will help protect your account while everyone else gets blown up.
If you’re a trader, keep this essay handy… It’ll help you keep a cool head no matter what the market does.