Papale on Stop Orders

By Steve Papale

For those who may have missed it this football season, there is a train wreck here in Chicago.  The Bears, who started the season with high hopes and a pretty good array of talent, have completely gone off the tracks.  There  has been a ton of talk on this so I figured I would add my two cents to the sea of noise.  Cutler is the main focus of the criticism – big money and poor performance.  So what should we do with him?   Play him – on the defensive line.  Put him up front with the horses. Since he can’t play offense I say try him on defense.  Make him make some tackles –  get his jersey dirty.  At lease he can’t throw any interceptions from there.

Last week we talked about some order types to use in both stock and options trading.  Today I want to continue with that conversation regarding the two order types – stop and stop limit.  To review, a stop is an order placed below the market on long positions and above the market on short positions.  They are designed to stop the losses incurred when the market moves in wrong direction for our position.

For example, if I am long 100 shares of IBM at $160, I may place a stop at $150.  In this order, when IBM trades at $150, my order becomes a sell at market order.  It can be an effective risk management tool however it does have a couple drawbacks.  First, if the market gaps down, we might get filled significantly below $150.  Second, specialists who can see the order may force the market down to the stop price, have the order executed and then move the market back up.  A stop limit is similar to a stop except once the trigger price is touched, the order becomes a limit at that price.  In the previous example, once IBM traded at $150, the order would become a sell limit at $150.  As all limits, we are not guaranteed a fill at that price unless the stock trades above the trigger in the case of a sell stop limit or below in the case of buy stop limit.

Using these orders on stocks are pretty straightforward.  However some extra caution should be exercised when using them with individual options.  First, due to changing IV and other factors, there is no way to predict with certainty at what underlying price the option will hit a stop price.  There are two price triggers that will execute the stop – the limit price either trading or offered in the case of a sell stop or bid in the case of a buy stop.  The last price should not be counted on as any particular option may not trade for hours or longer no matter what the underlying does.  If I am long a call at $5 and put a stop at $4, my order becomes a market order once the calls have a  $4 offer in the market.  That’s ok but the order is now vulnerable to slippage.  With the stop limit, the same idea only when the price is triggered, my order is a limit, just like with stocks.  You can also place these orders for spreads but the only trigger is an actual trade.  So if you have a spread with a sell stop at 5, the spread must trade at or below that price.  The risk here is the market moves in the wrong direction and no trade occur hence not triggering the stop.  The problem with spreads is no offer will trigger – only a trade.  So if you have spread that does not trade actively, you may not get triggered for a long time.  I would not recommend using this order type with spread trades and only carefully with individuals.  It is probably better to keep an eye on the underlying and the options and when you need to, place the order in the market as a limit order.

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