Yesterday I posted a video suggesting that traders consider using options instead of stops when trying to hedge overnight exposures. The rationale is that there is considerable movement in the overnight future that leads to gap openings when the US markets open for trading. Gap openings make it very risky for those who utilize stop and stop limit orders when hedging positions that are held overnight. Options, however, typically retain their protective features under those same circumstances.
The following is a chart of ES futures trading excluding the hours of 9:30am – 4:00pm Eastern time. There are a number of sessions that saw significant movement in one direction or another that resulted in gap openings when regular trading began:
Source: IBKR Trader Workstation
Remember that stop and stop limit orders are triggered when a stock or commodity’s price crosses a specified level. Those triggers are usually active during normal trading hours and those order types work reasonably well when price moves are relatively continuous. They work very poorly, however, when there are gaps in pricing.
Here is an example, let’s say a trader is long an actively traded, liquid stock that is trading at $28.50 and enters a sell stop order at $28. During normal trading hours and under normal circumstances it is reasonable to expect that the stock will trade at a range of prices before and after the stock trades at $28. Once that price is touched, triggering the stop order, the trader should expect an execution slightly below $28. Remember that a stop order becomes a market order once triggered, so the execution quality is not assured. If the trader opts for a stop limit order of $27.90 with a $28 trigger, there is also a reasonable likelihood that the trader would be filled within his parameters as long as there is sufficient liquidity in the stock.
Let us now assume that the trader was long those same shares overnight and placed the stop order with a longer-term time in force (GTC or GTD). If the stock opens above $28, the stop order is still helpful. If it opens below $28, the order is triggered by the opening price and becomes a market sell order at whatever that prevailing price may be. The trader can hope that the price is near his desired stop loss, but there are no guarantees. The stop or stop limit order is unlikely to provide the desired protection in the face of that gap opening,
If the trader hedged his long position by purchasing put options with a $28 strike price instead, those options would be likely to appreciate in value at a level commensurate with the stock’s move and the option’s delta. There are many variables that influence options pricing, but a properly hedged trader could see his stock losses offset by an options gain.
That said, options are not a panacea. Options cost money, and many traders would not find it beneficial to increase the total cost of their position. Options also decay over time, meaning their cost is less likely to be recouped the longer they are held. Stop and stop limit orders, however, cost nothing to enter. They are subject to standard commissions if they result in a trade, as would any execution that closes the stock position.
In a sense, it’s another example of “you get what you pay for.” The free solution, stop and stop limit orders, have limited value in protecting overnight positions. The paid solution, option purchases, offer the potential complete protection but can be a drag on returns. Risk management always involves a set of choices, including how much risk one is willing to take in exchange for a desired return. There is no single solution that works all the time for every trader, but it is important that every trader be able to properly assess which tools suit him best in a given situation.
Stop order: A Stop order becomes a market order to buy or sell securities or commodities once the specified stop price is attained or penetrated. A Stop order is not guaranteed a specific execution price.
Stope limit order: A Stop Limit order is similar to a stop order in that a stop price will activate the order. However, unlike the stop order, which is submitted as a market order when elected, the stop limit order is submitted as a limit order.
Using Options Instead of Stops
Disclosure: Interactive Brokers
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Disclosure: Options Trading
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