Do You Use a Stop Loss? Add This Protection Tool…
Managing risk is the most important aspect of any trading plan.
This is true for every trader under the sun. It doesn’t matter how long you have been trading, what market you trade in or how much capital you have, risk management needs to be the first thing on your mind.
For many traders the only way they approach risk management is through stop loss orders. They will put on a trade, pick a level they want to get out at if it goes against them, then set a stop loss order.
This is a totally valid approach to managing risk but it doesn’t protect you as much as you might think.
Stop loss orders can fail in the event of overnight gaps or very fast moves. They also are less effective in stocks that don’t trade very much volume. Even if you have a stop loss in place there needs to be someone willing to buy at that level for you to get an exit.
This is why I want to go over the basics of what are called “protective put options.”
You can use the options market to setup more secure protection in your long or medium term stock trades without having to worry about them failing.
The Protective Put Option
This is one of the simplest options strategies to run. All you need to do to run this is buy a downside put in a stock you already own.
Owning this put will protect you against any moves below the option’s strike price. This happens because a put gives you the right to sell 100 shares of stock at the strike price before a certain time.
Let’s look at an example:
You are long stock 100 shares of XYZ at $100, you see the April 95 puts trading for $1.00
You are concerned that if the stock gets below the $95 level it will sell off hard so to protect yourself you buy the April 95 puts for $1.00.
The cost of this insurance policy is $100 ($1.00/share x 100 shares).
For this $100 premium your stock position is now protected from a move below $95.
Watch how this works…
Before April expiry the stock sells off to $85. You have the right to sell your stock for $95.
Your total loss on the stock is only $5 compared to $15.
This plus the premium you paid for the put makes your total loss per share $6.
Do you see how that worked?
The put protected you from a move below $95 and cut your losses by 60%.
While this seems like a simple strategy to run there are some things you need to think about.
Timing is a big one.
If you are looking to buy puts ahead of an event like earnings they will be expensive.
It would be like buying home insurance right before hurricane season.
Be mindful of how much you are paying for protection and make sure it makes sense and aligns with your overall goals.
Stop losses are a great way to manage risk but using protective puts is a more sophisticated way to protect your positions.
It doesn’t make sense in every single situation. But you should make yourself familiar with this strategy so you can hedge like an AlphaShark.
AKA, “The Alpha Shark”