When to choose hard vs. mental stops as an options trader is a topic that comes up frequently in my daily group coaching classes and one-on-one coaching sessions. The truth is, it is not an easy answer. When it comes to options, stop losses can be a little tricky as compared with an investor who buys and sells stock.
Bid/Ask Spreads
For one thing, bid/ask spreads tend to be a little wider for options, which means there is more ground to make up than there would be for many equities, which have a tighter bid/ask spread. There are plenty of times in options trading when you are thankful to just get back to breakeven on some trades because of the spreads. Imagine an option position that has four legs like an iron condor. If the bid/ask spreads are wide, think how difficult it would be to do a hard or mental stop loss trying to middle the market. What is “too spready” is up to each option trader to decide. Below is a general rule of thumb I use when it comes to stop losses and options.
Outrights
When buying or selling a single-legged option, I tend to use a hard stop if the bid/ask spread for the option is reasonable. You will have to decide what is reasonable and that is a discussion for another day as stated above. I will put in a sell stop loss for long positions and a buy stop loss for short positions. 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 0.03 wide (that can widen, however) so there is less chance for slippage or a worse fill with the exit order set if the position declines to 1.00 or lower by becoming a market order.
When buying or selling an option spread, a mental stop is usually more beneficial because the bid/ask spreads tend to be larger due to multiple legs. If the bid/ask spreads are generally tight, I still consider using a hard stop especially if I am fortunate enough to have previously taken a profit on some of the position. The screenshot below shows a potential vertical call debit spread (bull call) 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 1.00 or lower in value again. The bid/ask spread is now 0.16 wide instead of just 0.03 like above.
Finally
Whether you choose to use a mental or hard stop is completely up to you, but consider how wide the bid/ask spread is as well. In addition, some option traders might sway from their mental stops when that level is tested and actually lose more money because of lack of discipline. That too is a discussion for another time. I hope this will give you a few things to think about. The most important part is that you have a stop loss (mental or hard) in the first place.
John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.
One Response
If I hit my first target, I use a trailing stop at that point, depending on the option and the range of the daily option so i don’t have to keep an eye on the trade all day long. I don’t set a second target so I can let run as high as it will go. Usually a 10% or 15% TS.