Mental vs. Hard Stop: Which to Choose When

Posted on Friday, May 22, 2020 at 3:25 PM

What to consider when contemplating stop losses in option trading is a topic that comes up routinely in MTM’s Group Coaching class. When it comes to options, stop losses can be a little tricky. Bid-ask spreads tend to be a bit wider, which means there could be more “ground” to make up than there would be with many equities, which have a tighter bid-ask spread. In this blog I will explain the general rule of thumb I use when it comes to stop losses and options.

Outrights

When just buying or selling a single-legged option, I tend to use a hard stop if I deem the bid-ask spread reasonable. What is reasonable? That will be for you to decide, and you will form your opinions with more experience. Experience cannot be taught, and in this case opinions are formed over time. I will put in a sell stop loss for long positions and a buy stop loss for short positions. Because 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 $0.10 wide, so there is less chance for slippage or a worse fill with the exit order set if the position declines to $0.70.

Spreads

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 but only after becoming profitable on the position. 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 $0.30 in value. The bid-ask spread is now $0.15 wide instead of just $0.10 like above.

Whether you choose to use mental or hard stops is completely up to you. With the market continuing to be volatile, gaps on the open have become normal. In addition, bid-ask spreads tend to be wider right after the open. Keep that in mind too. I hope this will give you a few things to think about. The important part is that you have a stop loss decided on in the first place.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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