Options vs Stop Losses: Is it Worth It?

  • Thread starter John Creighto
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In summary, the conversation discusses the use of stop losses and put options as strategies for minimizing risk in the stock market. However, both strategies have their drawbacks and may not be effective in protecting against losses. The cost of buying put options can also be high, making it less viable for some investors. It is important to consider all scenarios and assumptions when using these strategies.
  • #1
John Creighto
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Through this downturn I've seen so many analysts suggest stop losses as a way to minimize risk. The strategy works like this. Your stock falls bellow the amount you are willing to lose then you sell. This to me sounds like buy high and sell low which is the exact opposite of what you want to do if you want to make money.

So alternatively, I wondered, if you are concerned about losing money why not buy some kind of option (a "put" to be specific) that let's you sell at a given price. That way no matter how far the market falls, you have the option of selling at the price you bought the option for. Anyway, when I looked at the numbers for one stock bellow and this strategy didn't seem too hot either.

So how much will this insurance cost you. Well, I chose IBM as a random stock. Here is the current stock price:

Last: 117.09 Change: -0.54 Volume: 5,120,042

Here are the quotes on puts:

Code: 
Strike Price	Symbol	Last	Chg	%Chg	Time Value	Bid	Ask	Vol	Open Interest
65.000	.IBMTM	NA	NA	NA	NA	NA	0.050	NA	NA
70.000	.IBMTN	0.070	NA	NA	0.050	NA	0.050	NA	160
75.000	.IBMTO	0.050	NA	NA	0.050	NA	0.050	NA	334
80.000	.IBMTP	0.020	NA	NA	0.050	NA	0.050	NA	451
85.000	.IBMTQ	0.050	NA	NA	0.050	NA	0.050	NA	3,049
90.000	.IBMTR	0.050	+0.01	+25.00%	0.050	NA	0.050	213	1,633
95.000	.IBMTS	0.080	+0.03	+60.00%	0.100	0.050	0.100	65	4,775
100.000	.IBMTT	0.100	-0.05	-33.33%	0.150	0.100	0.150	2,440	7,254
105.000	.IBMTA	0.300	unch	unch	0.300	0.250	0.300	349	8,013
110.000	.IBMTB	0.800	+0.05	+6.67%	0.800	0.750	0.800	1,598	8,386
115.000	.IBMTC	2.050	+0.15	+7.89%	2.100	2.000	2.100	3,108	8,074
120.000	.IBMTD	4.780	+0.47	+10.90%	1.890	4.600	4.800	755	2,511
125.000	.IBMTE	8.900	-0.10	-1.11%	0.990	8.700	8.900	333	976
130.000	.IBMTF	13.400	+0.10	+0.75%	0.690	13.500	13.600	10	757
135.000	.IBMTG	18.300	+0.40	+2.23%	0.690	18.300	18.600	2	107
140.000	.IBMTH	23.000	NA	NA	0.790	23.200	23.700	NA	33
145.000	.IBMTI	28.000	NA	NA	0.790	28.200	28.700	NA	20
http://moneycentral.msn.com/investor/options/default.asp?symbol=ibm

The option contracts tend to last for about a month. So say we don't want to lose more then 20%. Then our stock should not fall by a factor of more then 0.8 per year or (0.8)^(1/12)=0.9816. The current price multiplied by 0.9816 is 114.935544

The closest strike price to this is 115.00. The asking price is 2.100.

The asking price for this option is 1.8 % the price of the stock. Therefore to protect against a 1.8% loss in a month we would need to buy an option worth 1.8% the value of the stock.

This doesn't sound two effective, unless you consider there is a good chance of the stock jumping much more then 1.8% in a month. Not sure when this would happen. Maybe in a rally after a dip. Maybe if I consider some other scenarios it might work better.
 
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  • #2
there ain't no free lunch

you have to assume that derivatives are fairly prices, otherwise why would a knowledgeable trader sell them to you?

stop losses are also problematic as prices are not continuous - they can gap down well in excess of the stop price.
 
  • #3


I appreciate your curiosity and critical thinking about different strategies for minimizing risk in the stock market. It is important to carefully consider all options and weigh the costs and benefits before making any decisions.

In this case, you have correctly pointed out that using stop losses may result in selling stocks at a loss, which goes against the goal of making money. However, buying put options as a form of insurance also has its drawbacks, as you have highlighted in your analysis.

One thing to keep in mind is that options prices are influenced by various factors such as volatility, time to expiration, and the underlying stock's price movement. Therefore, the cost of buying options may vary depending on these factors and may not always be a fixed percentage of the stock's price.

Additionally, buying options requires a certain level of knowledge and understanding of the market, as well as the risks involved. It is not a foolproof strategy and can also result in losses if not used correctly.

Ultimately, as a scientist, I would suggest carefully researching and analyzing all available strategies, and perhaps consulting with a financial advisor, before making any decisions on how to manage risk in the stock market.
 

1. What is the difference between options and stop losses?

Options and stop losses are both risk management strategies used in trading. Options are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific time frame. Stop losses, on the other hand, are orders placed to automatically sell an asset when it reaches a certain price, in order to limit potential losses.

2. Which strategy is more effective for managing risk?

The effectiveness of options vs stop losses depends on the individual's risk tolerance and trading strategy. Options can provide more flexibility and potentially higher returns, but they also come with higher upfront costs and expiration dates. Stop losses, on the other hand, are more straightforward and can be used for any type of asset, but may result in greater losses if the market moves quickly.

3. Are options or stop losses better for minimizing losses?

Both options and stop losses can be effective at minimizing losses. However, stop losses are typically used for short-term trading, while options are better suited for longer-term investments. It is important to carefully consider the risk-reward ratio and choose the strategy that best fits your trading goals and risk tolerance.

4. Can options and stop losses be used together?

Yes, options and stop losses can be used together as part of a comprehensive risk management plan. For example, an investor can use a stop loss order to limit potential losses on a stock, while also purchasing a put option as an insurance policy in case the stock price drops significantly.

5. Is it worth it to use options and stop losses?

The decision to use options and stop losses ultimately depends on an individual's trading goals and risk tolerance. Both strategies can be effective in managing risk, but they also come with their own costs and limitations. It is important to carefully consider your investment goals and consult with a financial advisor before utilizing these strategies.

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