Thursday, July 10, 2008

Putting stops on options

One thing I think is critical for any option trader weather they are an option seller or a buyer is a stop. Just like stock traders everyone who trades options should have a stop that tells them when to get out of a trade.

There are a couple different ways you can go about placing a stop on an option. The first is placing a stop loss based on the price of the option itself. Many traders will feel that this is the best way to go about placing a stop.

It helps you to manage the loss that you might inquire while trading. Here is an example; if you only want to risk $1000 on a trade you could have a stop on the option to exit if the option loses $1000 or more. That can help you to keep your losses short.

Also if you are a big risk to reward trader you can more accurately control the amount of risk you are taking with this strategy.

The second way to place a stop on an option is through a contingency order. This order lets you enter or exit an option based on the price of the stock itself. In other words you can place an order to exit a trade if the stock gets to $50 or lower.

If the stock ever gets to $50 or lower you will automatically exit the trade. Although this way of trading will make it harder to develop a proper risk to reward ratio it can help you be a little more accurate. Because options aren’t 100% priced based off of the price of the stock placing a stop solely on the price of the option can sometimes make you either stay in a trade too long or exit too early.

Every option trader must find the way that works best for them. One more thing I would like to add. Many people will place a mental stop. This means that they say they will sell if a stock gets to a certain level. This can be devastating because not many have the disciple to actually sell at that point.

These people may decide that they will just wait and see. Or they will move their stop lower which is a bad thing to do. Once you decide your stop you must place the order.

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