Solving the puzzle for setting a stop loss for an option trade!

Options are time-sensitive, and their value erodes with each passing day due to time decay. Placing stop-loss orders on a closing basis could result in more significant losses.

Introduction

Traders need to keep stop-loss levels in mind to protect their investments and limit potential losses. However, when it comes to placing a stop-loss for an option trade, there's often a state of confusion: should it be based on the option premium or the underlying asset value? In this article, we delve deep into the nuances of applying a stop-loss on option positions, specifically addressing the question of whether it's optimal to use stop-loss on a closing basis, similar to spot market transactions.

Understanding Stop-Loss in Options Trading

When trading equity options, it's crucial to base your stop-loss on the underlying price. Why? Options are chosen over the underlying asset because they require less trading capital, making them a popular choice among traders. The primary objective when buying call options, for example, is to bet on the underlying asset's upward movement. Additionally, options traders can profit from volatility fluctuations by leveraging an option's vega.

Logically, if the underlying asset begins to decline, it's wise to consider closing your call position to limit your losses. Imagine you've purchased a Reliance Industries October call option with a strike price of 2200. If the stock price drops to, let's say, Rs 2155, it might be time to close your long call position and minimize your losses.

For index options, it's recommended to base your stop-loss on index futures rather than the spot index. The rationale behind this choice is that index futures are tradable instruments, while the spot index is not. Understanding market sentiment is more meaningful when considering actual demand driving contract prices, as is the case with futures.

Intraday Basis vs. Closing Basis

Now, the crucial aspect to consider is the frequency of your stop-loss execution. Options are time-sensitive, and their value erodes with each passing day due to time decay. Placing stop-loss orders on a closing basis could result in more significant losses.

When the underlying asset declines, the call option's price falls, influenced by its delta. This means that your long call position will experience losses due to both delta and theta when the underlying asset moves downward. Conversely, it will gain due to delta when the underlying moves upward. The impact of gamma on long positions is relatively small.

Considering the size of delta and theta, the unrealized losses on your options positions could become substantial. Furthermore, given that theta consistently erodes the value of long positions, it's uncertain whether the option's price can recover unrealized losses if the underlying asset moves up the next day or in the days that follow. This is another reason why a stop-loss on a closing basis may not be the optimal choice for options.

In contrast, a closing basis stop-loss is more suitable for underlying assets since these positions are not subject to time decay. While there's an opportunity cost associated with holding a losing position, it's a calculated risk that traders should take to avoid missing out on potential profit opportunities when the asset's price rebounds after a sharp intraday decline.

Conclusion

In options trading, the application of stop-loss orders is a critical element in managing risk. The choice of whether to use a closing basis or an intraday basis for your stop-loss should be driven by the unique characteristics of options. With options being sensitive to time decay and influenced by delta, theta, and gamma, it's clear that a closing basis stop-loss may not be the most effective strategy.

To protect your investments and optimize your trading strategy, consider setting stop-loss levels based on the underlying asset's price, and do so on an intraday basis. This approach allows you to adapt to the dynamic nature of options and minimize potential losses while maximizing profit potential. In the world of options trading, adaptability and informed decision-making are the keys to success.

Disclaimer: The article is for informational purposes only and not investment advice.