The most commonly used tool of risk management among retail traders is the protective stop order. While useful, the protective stop order draws one pronounced criticism among traders, namely, that it results in a position being prematurely "stopped out". In other words, prices move sharply through the stop price, thereby closing the position at a loss, only to later recover. What may have turned out to be a profitable trade was, instead, a loser. What can a trader do?

As an alternative to the protective stop order, the trader can buy an option. With this approach, the trader risks the same amount of money, yet the position can tolerate extreme price movements.

For example, consider the case of CBOT September Oats (see diagram). Assume that it is the latter half of July, 2003 and the trader has identified an historical level of support at 137 ½ cents, shown by the red solid line, which in the future will mark a level of resistance. If prices break through that level, the trader will buy one contract with the expectation of a continued price increase. On July 29, the price breaks through that level and the trader buys one contract at the close of 142 cents.

Scenario One: Protective Stop Order
The trader is willing to risk $350 on the trade, excluding commission and other fees, and correspondingly enters a GTC (good 'till canceled) stop order to sell one September Oats contract at 135 cents. (Each cent is worth $50 per contract.)

Unfortunately, on August 5, prices move through 135 cents and the stop order is filled. The position is closed at a loss of $350 plus commission and fees. The subsequent recovery in the price of Oats provides a classic example of a trade being prematurely "stopped out".

Scenario Two: Protective Put Option
The trader can instead manage the risk of the long futures contract by purchasing a put option. Let's say that on July 29, the same day that the long position is established, the trader buys the September Oats put option struck at 140 cents and pays 5 cents equal to $250, excluding commission and fees. (That was the high price of the day for that option.)

The put option provides a selling price of 140 cents and this is the protection. If the price of September Oats is below 140 cents at the time of the option's expiration, then the put option will be exercised into a short futures position at 140 cents. This, in turn, will automatically close the long futures position previously established. The total loss, in this case, will be $250 (the cost of the option), plus $100 (the difference between the buy and sell price of the futures, i.e. (142-140) cents x $50/cent), excluding commission and other fees. Thus, with this strategy, the maximum loss is fixed at $350.

Conclusion:

• Advantage: Options
  The protective option enables the trade to tolerate temporary price reversals where a protective stop order would have otherwise closed the position.
• Advantage: Options
  The maximum loss of the trade is fixed with the protective option regardless of market liquidity or gapping price behavior. In contrast, a stop order does not fix maximum loss: a gap through the stop price will result in greater-than-expected loss on the position.
• Advantage: Stop Order
  It does not cost any money to place a protective stop order, not even a commission expense. Protection using an option, on the other hand, requires the purchase of the option and associated commission expense. Furthermore, the option price must be paid even if the protection is never used and this will hamper overall trading profitability. When the option expires (worthless), then another option must be purchased for continued protection.
• Advantage: Stop Order
  Stop orders can be used easily in any market. In contrast, the availability and pricing of some option markets will make it difficult to engineer a suitable option protection strategy. For example, the trader may find that the candidate options are too expensive, or that the strike prices are too far apart.

There is no rule for determining which provides the better protection in the context of a profitable trading program: the stop order or an option. Armed with knowledge of both, the trader can make their own determination based on their personal risk tolerance and trading objectives. Simulated trading provides an ideal environment in which the long-run profitability using each approach can be tested for the trader's own particular program.

Article Reprinted with the permission of Rick Thachuk, of World Link Futures
Rick has been involved in various aspects of the futures and options markets, including positions as an economist and derivatives market analyst at the Bank of Canada and Finex. In 1996, he founded World Link Futures Inc., an educational Commodity Trading Advisor serving the beginning trader.

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