Most professional traders employ some form of downside protection. And it’s even more important for beginner traders to know risk management techniques to hedge their positions against losses caused by their long positions turning against them.
But the biggest issue in this situation is figuring out how much downside protection should be in place given the risk and potential return on the trade.
I find that sometimes put options work best…
But from a practical perspective, the position doesn’t always make sense because the option may have low liquidity, the spread may be too wide or the option that fits my requirements just doesn’t give me enough risk protection or time value.
Risk Management Techniques for Beginner Traders: Put Options
There are two instances when put options would be a better risk management technique for beginner traders, offering more protection against downside movement than stop orders.
The first situation is when a price gap occurs to the downside…
In this case, the trader using a stop-loss order would get a price fill that’s much lower than the intended fill price because the gap opened below the stop-loss level… also causing the risk on the trade to increase by the amount the stock opened below the intended price level.
For example, let’s assume you purchased ABC stock at $100 per share with a stop-loss order at $90. A few days after you place your stop loss, the stock opens at $80 per share because its earnings were much lower than expected and it gaps down $20 at the open.
In this case, your sell stop would trigger and you would be filled at $80 instead of $90.
One possible way to avoid this scenario is to use stop-limit orders, and choose a limit price that’s a few points below your stop-loss order.
Risk Management Techniques for Beginner Traders: Stop-Limit Orders
Now let’s assume you placed the stop-loss order at $90 and a limit level on the trade at $85.
In this case, you could end up in a worse situation because instead of getting filled at $80, or the opening price the next day, your order would simply NOT get triggered because the opening was $5 below your limit price.
So you’d end up holding the position and risking even more to the downside unless the stock at some point during the session rallied back up to the $85 level… which may or may not happen.
Neither of the two stop-loss examples offer a feasible solution to adequately protect your position against gaps to the downside.
An ordinary stop loss will increase your risk — and in effect your loss level — beyond the level you intended. If you use a stop-limit order and the gap opens below your limit price, the trade won’t execute. And unless you’re monitoring the stock in real time, you may end up increasing your downside risk well beyond the intended level on the trade.
The other situation, and one I dislike a lot, occurs when the stock moves lower to trigger the stop-price level and then rebounds to trade higher once again.
This situation can be super frustrating because even though you picked the right direction and the stock rallied after falling, you didn’t participate in the move because you were stopped out prematurely.
Things to Keep in Mind
Unfortunately, there’s no way to avoid these two scenarios when applying stop-loss orders to your trades for protection.
In some situations, however, using a stop-loss order may end up being one of the better risk management techniques for beginner traders.
For example, if you’re day trading and don’t have any overnight risk, the odds of a major gap occurring during the trading session is rather slim — especially if you’re trading assets that have reasonable levels of liquidity.
But stop-loss orders may be a better fit than put options when you’re making a long-term investment or using a trend approach to the markets.
In these situations, there’s no way to figure out how much time the trade will be held. And buying a bunch of put options may prove to be an expensive proposition over time, especially if the asset is intended for long-term capital appreciation.
I find that put options work best when my holding period is limited to no more than a few months.
This allows me to buy an out-of-the-money put option that has enough time value to offer me adequate protection without the high cost that comes with buying an option that’s at the money.
It’s a great trade off between risk and reward and most of the time I end up liquidating the option before it expires and recouping some of the cost that was paid for it.
In conclusion, whether you buy a put option or use a stop-loss order is best determined by your intended holding period, the volatility or trading range of the underlying asset and whether the asset you’re holding is prone to big price gaps.
You have to take these factors into account and consider the upside and downside of each risk management technique — especially if you’re a beginner trader — before deciding whether to use stop-loss orders or put options.
For more on topics like this, please check out: Learn to Swing Trade Options With This Beginner-Friendly Strategy and Don’t Make Simple Trading Strategies Complicated.
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All the best,
Senior Strategist, WealthPress