Option Investor
Trader's Corner

Stop Orders in a Fast-Moving Market

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It happened again. The OEX was moving against my position. I had placed OCO (one cancels other) orders to take me out of my long call position if the OEX dropped too far or else met my profit goal, so I hadn't been too worried. I didn't like the fact that I was about to be stopped, but traders must expect that some trades would be losing ones.

I just didn't expect the losses to be as big as they turned out to be. The quoted price of the option blew right through that stop without the stop order being filled. Finally, when the calculated value of the call was $2.00 below the order's stop price, I cancelled the OCO orders and placed a limit order to take me out of the position.

Trading in a fast market requires adjustments to your trading plans. Those plans should include extra vigilance even when a stop is set. To understand what happened, it's important to understand how those stop orders are filled. With my broker, a stop order is activated when the option trades at or below the price at which the stop is set. For example, if I had set a stop order for an OEX call at $11.50 and that call trades at $11.40, my stop order will become an active order and will be filled at market.

In regular times, that system works quite well. The OEX drops. Its options are usually liquid, frequently traded. That call trades at a price that triggers the stop, and the OEX doesn't jump around too much in the time it takes that stop order to be active and for the order to fill at market price. Traders expect some slippage, but usually in a liquid options market like the OEX's, the slippage isn't too bad.

No so in a fast market. When the OEX suddenly drops five points in a ten-second interval, it may be that not many call buyers step up to the plate during that ten-second interval. Bid and ask prices for the options drop quickly and much value is lost before someone buys the call at the lower price, the stop is triggered, and the call is sold at market, perhaps at an even lower price if the OEX has continued dropping during the interval.

So, what do you do? Trading without stops is not the right choice. Even experienced traders can fall into the deer-in-the-headlights reaction when a sudden move catches them unaware. Some traders set just-in-case stops to protect them against such deer-in-the-headlights reactions but plan to be vigilant and negotiate their own exit ahead of the stop and between the bid and the ask. It's of course important to cancel your existing stop order before negotiating your own exit.

Another alternative is to talk to your broker about the merits of a contingency stop order based on the price of the underlying versus the price of the option. Some brokerages offer another possibility. At least one broker, Think or Swim, offers several alternatives to the standard stop order. Think or Swim customers can choose to have their stop orders activated or triggered three different ways: when the asset--a call option in this case--trades at the stop price, when the bid falls to the stop price or when the ask falls to the stop price. If my broker had offered that possibility, I could have set the stop to be triggered when the bid hit a certain number.

If I'd been able to set my stop order based on the bid or ask rather than an actual trading price, I suspect my orders might have been triggered sooner, but I still would have experienced slippage. Couple the wide bid/ask spreads that the increased volatility have brought about with the slippage that should be expected when a stop is triggered, trading options becomes less advantageous than at some other times in the past. Add in the erratic nature of the markets these days, and option traders are put at another disadvantage.

In the words of an options market maker a few weeks ago, these conditions require that options traders be "more right" than they've ever been before. There's no room for error here. Re-familiarize yourself with the types of stops your broker offers, if you haven't done so previously. If you find that your broker handles stops as mine does, be aware that slippage might greatly impact the drawdown you experience when a trade goes wrong. Do set stops, but this isn't a time to go off and do something else while the trade unfolds. Forego the trade if you can't watch. Consider your stop a "just in case" stop to take you out if your attention was misdirected for a few minutes or you just did your deer-in-the-headlights imitation, but plan to pull that stop and negotiate your own exit if you can trust yourself to do that. If you can't, then slippage is better than letting the option run to zero.

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