Trading Without a Net: Why I Don't Use Stops on Options Trades

Eddie Braverman's picture
Rank: The Pro | 21,117

mod (Andy) note: "Blast from the past - Best of Eddie" - This one is originally from September 2010. If there's an old post from Eddie you'd like to see up again shoot me a message.

I've received a few messages from you guys about my recent DXD and SLV options trades, and I wanted to take a minute to explain part of my trading strategy when it comes to options. As you know, the silver trade is working well so far (up 18% in 8 trading days), the DXD trade not so much (down 66% in 9 trading days).

When you invest in something - anything - the value of it should rise immediately. If you buy a stock, bond, commodity, or derivative and it doesn't go up immediately, you were either early (best case) or wrong (worst case). Anyone who tells you otherwise is trying to sell you something. In order to be a long-term success as a trader, you have to cut your losses short and let your profits run. Stop loss orders are an excellent way to achieve that level of risk management.

I am generally in favor of using stops on a trade. For example, if I go long a stock I will generally set a stop loss 15% below my entry point. In other words, if I buy XYZ for $10 a share I cut my loss short if it drops to $8.50 a share. Mind you, this is on stocks I'm trading. If I'm buying something for the long haul, I generally don't mind so much if it gets a little cheaper and I can buy more.

Likewise, when I'm right about a stock and it goes up immediately, I'll usually place a trailing stop to lock in my profit if the stock turns around and starts dropping. You can't lose what you don't put in the middle. I usually set trailing stops much tighter than stop loss orders because I want to lock in maximum profit. If I have a stock rise 15% from where I bought it, I'll usually place a trailing stop 5% below the market price. That way the stock can continue to go higher and make money for me, but it gets sold the minute it decides to head south.

This is all really basic trading strategy and I don't mean to insult anyone's intelligence by explaining it. I just wanted to provide some context for when I explain why I don't use stops on option trades.

Maybe you have to be a veteran futures trader to fully get this (or at least be dumb enough to agree with it), but options have a built-in stop. When trading options, you can never lose more than 100% of your investment. I can hear some of you snickering right now, but I'm serious. Anyone who has traded straight futures will tell you that if shit goes sideways, you can be on the hook for a lot more than 100% of your investment. You might face a margin call where you have to send in three or four times your initial investment just to get back to zero. And that sucks ass. So knowing your downside is limited to 100% can be oddly comforting.

Options are a leverage play, and volatility goes hand in hand with leverage. The more leverage you have, the more violent the swings are. Think about it: the big news when the crisis struck was that some banks were leveraged at 30:1. That kind of leverage can really amplify gains when you're right about something, but if it's used against you, that kind of leverage will destroy you quickly.

So let's look at the DXD trade. DXD is a leveraged ETF that rises in value as the DOW drops, and vice versa. It is leveraged at 2:1, so if the DOW rises by 2% in a day, DXD drops by 4%. Stock options represent 100 shares of the underlying security. So if you buy options on IBM, you're taking a position in IBM leveraged at 100:1; the percentage gains and losses can be profound depending on how much IBM moves and in which direction. By buying options on DXD, you are essentially leveraging the DOW at 200:1, which is massive leverage (100:1 for the option, and the underlying is already leveraged at 2:1, hence 200:1 implied leverage).

Any time you're leveraged that much, stops can really cause you headaches. Because of the volatility involved, you can get stopped out of the market and then see the market whipsaw back another 50%. Then you're booking a big loss when you should be celebrating.

When I was trading commodities options for customers, my compliance department more or less insisted that I use stops. I would set the initial stop loss at 50% of the investment and still got stopped out more times than I care to remember only to watch the market rebound immediately. The NYMEX open-outcry pits were such a shitshow back in the day that I'm convinced the floor traders would purposely drop the market just to bang out the stops before taking the market higher.

Think about it in mathematical terms. 200:1 leverage is essentially a .5% down payment on the underlying security. So if you bought a house today for $200,000 and only put $1,000 down to do it, and that house rose by 15%, you'd be dancing. You just made a $29,000 profit on $1,000 investment. If it did the opposite, however, would you throw in another $29,000 just to get to even, or would you put the keys in the mailbox and walk away from the $1,000 you put up (moral arguments aside)?

That's the opportunity afforded to you by trading options on a leveraged ETF. If you're wrong, you can put the keys in the mailbox and walk away from the trade without losing a moment's sleep (assuming you didn't bet your rent on the trade). And that's why I don't use stops when I'm trading options. My downside is limited to 100%, but the last time I rang the cash register on DXD calls I pocketed 300% in under two weeks.

Incidentally, I'm not wrong about the trade. I was clearly early, but I'm not wrong. Wait and see.

Comments (29)

Sep 29, 2010

Great stuff Ed, thanks again man.

If I had asked people what they wanted, they would have said faster horses - Henry Ford

Sep 29, 2010

I puked some shorts on ES minis that I'd been fighting all month Ed - good luck on this one.

Out of curiosity, what is your target upside on the DXD play? Are you in the Prechter camp, expecting S&P sub-800?

Sep 29, 2010

No, I can't really say that. At least not on this particular trade. I'm looking for an exit somewhere between $28-29 on the DXD which would probably be around DOW 10,000. Ultimately a total meltdown isn't out of the question, and I have a lot of respect for Prechter's analysis, but I just don't look that far ahead from a trading standpoint.

Overall I'm bearish on the market, but I don't buy LEAPS to that effect.

Sep 29, 2010

Another legit post. I've been in and out on calls of TBT. Another one with implied volatility of 200:1.

Keep the options posts rolling.

Sep 29, 2010
moneyrunner:

Another legit post. I've been in and out on calls of TBT. Another one with implied volatility of 200:1.

Keep the options posts rolling.

moneyrunner, how do you feel about LEAPS on TBT? i was looking at 2012 strike $36 . feel it would be a great way to play long term inflation and the effect of QE II when it hits

Sep 30, 2010
kryptic:
moneyrunner:

Another legit post. I've been in and out on calls of TBT. Another one with implied volatility of 200:1.

Keep the options posts rolling.

moneyrunner, how do you feel about LEAPS on TBT? i was looking at 2012 strike $36 . feel it would be a great way to play long term inflation and the effect of QE II when it hits

Kryptic,

The only thing with QEII is, we don't quite know where the Fed will intervene. The Fed could buy government debt to further depress the yield on Treasuries. Read this article: http://www.foxbusiness.com/markets/2010/08/10/fed-...
"In today' statement, the Fed said it will reinvest proceeds from expiring mortgage-backed securities into longer-term U.S. Treasurys, which should serve to keep rates on Treasurys low. The next step after that could be new purchases of government bonds."

Nevertheless, at some point this bull market in bonds will come to a screeching halt, when it is least expected. Something will happen, such as a Treasury auction where no one shows up.

If you consider the bond market a bubble in the making, consider how much the bubble can inflate before it pops. It will go on until you think it will never end. Your capital can drain quickly betting on its downfall so your timing is critical. I wouldn't load up on these trades, but you can buy dips and trade in and out of it until the move begins, but when it does, buckle up for the ride of your life.

Sep 29, 2010

Thanks for the post Ed! Im new to all this so it really helps to read posts such as yours.

Sep 29, 2010

id highly argue against something needing to go up and to hit out immediately if it doesnt, especially when you need to go ahead and add spreads into the picture as a portion of the transaction cost and the liquidity of the stock if you are to go ahead and accumulate a sizeable position you cant simply hit out when it is very spready

Sep 29, 2010

shorttheworld,

Agreed, but then accumulating a position isn't trading, it's investing. Ideally, you're not buying stocks or options with 15%+ spreads in this day and age. That would be a stock trading $10 x $11.50.

The fact is, if a trade (or investment, for that matter) immediately drops 15% or more after you buy it, you were very early to the party at best. It's a clear sign the capital could have been better allocated elsewhere for the time being.

Sep 29, 2010

Ok, am not big on trading myself ( that is an understatement , let us just i am an idiot on the matter ) but how do you buy silver, like if you go to your broker what would you ask from him ?? sorry for the absolutely dumb question.....

Maybe I do not have quotes under my name on google, but I KEEP IT REAL

Sep 29, 2010

Two Points:

  1. Emphasis on you can't lose more than a 100% when LONG and option contract (not short).
  2. The downside 100% vs upside 300% can be very misleading. You can achieve this payout structure though a number of option trading strategies, but let's take your long call example. I've back tested a number of these strategies. The payout is consistent with their typical outcome. If you enter this strategy 100 times (ignore compounding) then you will typically lose 75% (down 100%) of the time and win 25% (up 300%) of the time. You net zero (ignoring trans costs). These markets are very efficient. This is no lopsided roulette wheel.

So many of the traders out there are a joke. Anyone can lever up and hit a few big trades. I'll admit that the true quants have found some anomalies, but bankers grinding out deals and earning fee's is way more legit than you tarot card reading traders.

Sep 29, 2010
BCbanker:

So many of the traders out there are a joke. Anyone can lever up and hit a few big trades. I'll admit that the true quants have found some anomalies, but bankers grinding out deals and earning fee's is way more legit than you tarot card reading traders.

LOL. Then how come we make so much more money?

Sep 29, 2010
BCbanker:

So many of the traders out there are a joke. Anyone can lever up and hit a few big trades. I'll admit that the true quants have found some anomalies, but bankers grinding out deals and earning fee's is way more legit than you tarot card reading traders.

I would rather trade then bank any day of the week. Bankers have no balls. At least when traders get their asses handed to them, they lose their own money instead of borrowing mine.

Sep 29, 2010

PMs <> Traders

There are stand out traders who really kill it, but they are outliers.

Sep 29, 2010

OP do you ever say fuck it and hold options till expiration ?

Sep 29, 2010
pikachu:

OP do you ever say fuck it and hold options till expiration ?

Quite often, unfortunately.

If you're asking whether I exercise in-the-money options at expiration, however, I almost never do. Defeats the purpose.

Sep 29, 2010

Soitwouldseem,

I am pretty sure you would just prefer having a job as you clearly have no fcking clue what you are talking about. You do realize that "traders" (unless you are referring to individuals sitting at home J'ing off) trade other people's money and played a huge role in the financial meltdown and bank bailouts.

Sep 29, 2010
junkbondswap:

Soitwouldseem,

I am pretty sure you would just prefer having a job as you clearly have no fcking clue what you are talking about. You do realize that "traders" (unless you are referring to individuals sitting at home J'ing off) trade other people's money and played a huge role in the financial meltdown and bank bailouts.

Actually, I would rather be a physicist. Im talking about prop traders. As far as I can recall no prop shop received bailout money. Are you having a bad day, or did you just realize that chicks dont get wet when you tell them that you are a banker, and they usually just think that you are a teller at Chase. And to make matters while you are correcting them and explaining your banking greatness, she leaves you to get grinded on by some unemployed hippster. Ahh C'est la vie.

Sep 29, 2010

Doesn't seem like a great long term play on TBT. That LEAP trades at $4 right now. That stock would have to pop from $32.21 to $40 just to break even (profit on any time value there depending on how long term we're talking). That's a 25% move.

Sep 29, 2010

That makes sense, but I was hoping on banking on a spike in volatility as well and the fact that a 25% move for a levered ETF is likely if we see a big dip (I'm incredibly bearish). My perspective: QE II + correction + volatility = run up in TBT as people move to hedge inflation and risk in general ...

Idk though.. I've been bearish for a while but every time, something ends up happening and the bulls keep driving the market higher

Sep 29, 2010

Hey Eddie, isn't a 15% stop loss way more than the advice traditionally espoused (generally from 1-3% total capital risked per trade). Although this is given in terms of your total trading capital, I'm assuming you don't have many trades going on at once. What's your reasoning behind that number?

Sep 30, 2010

15% is a lot of room to the downside, and I often trade with tighter stops than that. I was mainly using it as an example. But it's true: I usually don't have more than 2 or 3 trades on at one time.

Sep 30, 2010

I like the DXD play we havent seen much of a shakeout and we have ultimately been rangebound past several months. I am neither bullish nor bearish but we could potentially see a 500-600 point slide in the dow over a few day span. How far OTM did you buy? One of the interesting things about options is the leverage afforded varies with your delta. a Deep in the money call in effect gives you a different type of leverage then a deep out of the money call.

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.

Sep 30, 2010

I actually bought in-the-money (at the time) 25s.

Sep 30, 2010

I don't think bonds will really suffer until risk assets actually take off. QE2 sounds like it should depress yields further and unless stock make a huge surge, people will continue to look at treasuries for safety. The inflection point where stocks appear 'safer' than treasuries (QE3 perhaps?) is where the magic will happen. I'm hoping someone comes out with an ultra-long govt debt ETF (I'm talking ultra-long maturities, although leverage would be nice as well) because the crash will be even worse.

Oct 1, 2010

Are you doing this as a retail options trader? The MM's have such a huge edge that I can't see how anyone could make $$$$$ betting against them (yes I know they delta hedge but still). Options are very much a zero sum game and those kids at SIG and the banks control pricing. How often do you get filled within the spread and how many lots are you moving around?

Mar 23, 2013

I was going to say something about how retail options trading is whatever. But I assume Mr. Braverman knows what he's doing. Still though, everyone else: don't.

northeast1:

Options are very much a zero sum game and those kids at SIG and the banks control pricing.

Also, this guy knew what was up.

Jun 8, 2013
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