Whenever there is a discussion on stop losses, no matter what is being traded, there are several points of view and most times it is subjective. When it comes to options, it can get a little trickier mostly due to generally wider bid/ask spreads than, say, equities. And unless there is a naked option position (selling an option without holding a position in the underlying), many option traders will argue, and rightly so, that there is an inherent stop loss to options because max risk is usually defined.

Hard Stops and Mental Stops

A hard stop is when a trader puts an actual order out there. I use a market stop, which means the trade becomes a market order to sell or buy once the premium for an option trader reaches a certain level. For example, if you bought a call for 2.00 and used a sell market stop at 1.50, the position would sell the call option at 1.50 or lower once 1.50 has been touched. With a mental stop, the trader does the work. If he is looking to exit at 1.50 from the above example and does not use a hard stop, he will have to execute the sell order himself when appropriate. This opens the door to letting emotions dictate your execution. Of course, that is a blog for another time.

Outrights

When just buying or selling a single-legged option, I tend to use a hard stop if the bid/ask spread is respectable. What is respectable? I get that question all the time. To me, it is one you need to answer for yourself with some experience trading options. Over time, you will know what is acceptable to you for not just stop losses but entering trades as well. I also like to consider the 10% rule. The bid/ask spread should be no larger than 10% of the bid price. For example, if the bid is 2.50 the ask should be no larger than 2.75 ((2.50 X 10%) + 2.50).

I will put in a sell stop loss for debit positions and a buy stop loss for credit positions. The reason behind this is that since there is only a single leg, the bid/ask spread is usually tighter. The screenshot below is a stop loss on a long call position. The current bid/ask spread is only 0.06 wide so there is less chance for slippage or a worse fill with the exit order set if the position declines to 1.10. Even if it is a single leg position, if the spread is too wide, I will use a mental stop.

When buying or selling an option spread, a mental stop is usually more beneficial because the bid/ask spreads tend to be (but are not always) larger due to multiple legs. If the bid/ask spreads are generally tight, I still consider using a hard stop. The screenshot below shows a potential vertical call debit spread and a stop loss. Notice that the bid/ask spread is larger than the long call listed above. Here the stop loss is set to exit if the position drops to 7.00 in value. The bid/ask spread is now 0.60 wide instead of just 0.06 like above.

Finally

There are a lot of things to think about when debating on stop losses and options. Like everything in options, there is a trade-off. Mental stops also require a certain amount of discipline in which emotions can get in the way. The important part is that you have a stop loss in the first place and stick to it.

John Kmiecik, Market Taker Mentoring