I learned a lot about trading when I first got in this business as a clerk for a very active trader of stocks and index futures. I assumed he must be pretty patriotic as he had a sign on one of his 10 monitors that said USA!! I quickly learned that it was actually an acronym for a reminder to himself: USE STOPS ALWAYS.
A Stop of course, is a hard sell or buy order (depending whether long or short the underlying) to close a loss (or a winner that is leaking the wrong way) before it becomes worse. Generally, stops are used to mitigate losses while targets are levels identified ahead of time where one would like to take profits on a winner.
While entry points for short term directional trades would always prove critical, they were often a bit arbitrary. Therefore much attention was paid at arriving at the proper stop, remembering the ol’ trader saying to cut your losses quickly and let your profits ride.
My days were spent getting yelled at with a phone attached to one ear relaying buy, sell and stop orders to a broker in the S&P 500 futures pit at the CME in Chicago, and two hands on my keyboard ready to execute electronic orders in a few of my bosses picks to click for the day, usually consisting of any, or all of the following stocks: INTC, MSFT, XCIT, LCOS, AMZN, YHOO.
What was confusing to be me as a newbie was how well stops worked while trading index futures (usually filled within decimals, then a tiny, if not at it) but how there seemed to be few ways to ensure similar closing executions for stocks. The real problem with stocks back in the day was that you could only trade so much volume electronically. Large size needed to be negotiated with a Nasdaq market maker, or a market made with a specialist on the floor. This could be time consuming in fast markets and it was nearly impossible to set a hard stop in a volatile stock. One of the huge differences between trading futures and stocks with stops is the potential for gap risk in a stock when the market is NOT open. Futures trade day and night electronically, and while liquidity may not always be great, there is always a bid to hit or an offer to take. That’s not true in stocks as market moving news usually comes out in non market hours, stocks have massive gap risk.
Which brings me to options and why we are passionate about one of their main uses: risk management. When I do work on a stock, and convince myself of an entry, but want to set my stop fairly tight, I can do so by using near or in the money option trade structures. Generally we are not fans just owning options, but in situations like our Walmart (WMT) trade from April 2nd it can make a lot of sense. While we had fundamental reasons to take a shot on the long side, the technical set up appears to be at a sort of make or break. With the stock at $81 I was inclined to take a shot on the long side, but really don’t want to own below $80. Here was the trade and rationale:
TRADE: WMT ($81.10) Buy June 80/85/90 Call Butterfly for 1.35
Break-Even on June expiration:
Profits: between 81.35 and 88.65 make up to 3.65, max gain of 3.65 at 85
Losses: up to 1.35 between 80 and 81.35 & between 88.65 and 90, with max loss of 1.35 below 80 or above 90
Rationale: For all intents and purposes, I have set my stop at 80 with the max loss I can take being 1.35. I cannot lose more than the premium that I spent. The worst case scenario in the other direction for a trade like this is that I get the direction too right and the stock rallies above 88.65 and I start to lose money.
And here was the chart from April 2nd:
With the stock at $81.10 I am only risking $1.35, with a stop at $80, with an upside break-even up 25 cents. And a wide range of potential profitability back towards the prior highs, giving me more than two months to have this play out. As a trader I have created a trade (whether my thesis is right or wrong) where I have limited my losses by using a pre-ordained stop, giving it time to let profits run if they were to materialize.
We use these types of structures a lot on longs and we especially like them as stock alternatives and stock replacements. With the market near all time highs, using options in this way to play for breakouts in some of your holdings while defining your risk against the chance of a significant correction makes A LOT OF SENSE.
We’ll be putting some focus on this as we get deeper into earnings season and try to identify good option trades in some of these widely held names that seemed priced for perfection.