Smarter stop loss orders when trading starts with understanding the probability of touch vs the probability of expiring as it relates to a strike price. Most traders have the perceived assumption that stop loss orders help reduce risk but it couldn't be further from the truth as it relates to risk-defined strategies.
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In this video, I want to talk about how we can apply some smarter stop loss orders and techniques to our trading system.
So stop-loss orders are a popular topic of conversation when it comes to trading because of the perceived risk reduction nature and in closing trades that go bad early. However, it's important that you recognize that your risk of holding a paper loss is typically two times higher than the probability of actually losing on the trade at expiration.
And what this means is that sometimes you're going to have trades that go against you early that come back around and become winners, right? And obviously you'll have trades that go against you early, and they become losers.
But more often than not you'll have a lot of times where you enter a trade on the high probabilities side where the trade goes against you early and using a stop loss order might get you out early and guarantee a loss as you should have held on to the trade and just played through it.
So lets look at an example here just to prove this point. Inside of think or swim you can use the probability of touch functionality and feature. Again you don't need to have this in your broker platform if you're using think or swim, great.
If not you can assume because I'm going to prove it here that your probability of touch or your probability of holding a paper loss is two times the probability of being an actual loser or losing on the trade. So let's go over an example here so we can show you where we're talking about.
So, Oracle at the time that we're doing this video is trading around $41 and some change here, and you can see that the May contracts which have about 46 days to have all of these probabilities for each stripe price of being in the money.
And again we're working on just the call side right now. And then we also have the probability of touch. So lets go over each of these, so you know exactly what we're looking at. Basically what we're saying here is that the 43 call options for Oracle in May have a 20% (just rounded down) chance of being in the money at expiration.
What this means is that there's a 20% chance that Oracle trades from where it is now at 41.21 all the way up to and above 43 between now and expiration and stays up above that level. So, stays above that 43 level by expiration again which is 46 days away.
So if there's a 20% chance that Oracle ends above 43, then that also means that there's approximately an 80% chance that Oracle does not get up to the 43 strike between now and expiration. So if you were to sell the 43 calls, you could collect $28 a premium, and you'd have an 80% chance of success.
Again that's holding every trade in every scenario all the way to expiration you do this type of trade over and over and over again. You're going to win out about 80% of the time, that's what the numbers tell us, that's how the probabilities work. Now, most people understand that.
That's probably a very simple concept for you now that you're this far into our training here on track number 3 and what most traders end up doing is: they end up selling this and say "okay, now I'm going to put a stop loss order in that says 'if Oracle starts approaching my short strike at 43 then I'm going to be out of the trade completely'.
I'm going to use a stop loss order to protect myself". And that's logical, and this is why people do it, and I understand, and I get it. They say "okay, if Oracle starts trading from 41.21 all the way up to 43 and then starts trading at 43 I'm just going to immediately get out of the trade at whatever loss I have" because I'm going to protect myself, it's going to be risk reduction, I'm going to get out of a bad trade early, et cetera.
And the problem with that thinking is what we don't understand, or most traders don't understand that the probability of Oracle just trading up to and touching the 43 strike is almost 2 times the probability of it staying there.
So basically there's a 42% chance that Oracle trades from 41.21 up to and touches and trades at or above 43 between now and expiration. Think about this: a 42% chance that Oracle trades up to 4 3 between now and expiration.
But based on the entire trading history of Oracle, we know there's only a 20% chance that it stays there. Which means that most of the time when it goes up, and it touches or trades at 43 it will back off of that level.
And so you have to understand this concept this difference between the probability of a trade or a stock touching a strike price and the probability of it staying there. Because the probability of touch can often lead you to the stop loss orders that create more losing trades.
So if we look at it visually on the chart here you can see again we are looking at that 43 strike if Oracle is trading right about here and it's moving around by the time we did this video. But you can see it's still trading right around 41.
If we sold the 43 strike which was right here, there's a 42% chance that Oracle just trades up to and touches that level. Just touches it one time. If you have a stop-loss order immediately your order gets you out and guarantees a loss.
But the actual probability of it staying up here is only 20% so it could go up and it could touch and then come back down, right? And that's often what we see a lot of times.
So like, here back in this expiration cycle here you can see Oracle went up and touched that 43 strike multiple times and ended the expiration cycle down. But there were 3 times where it would have gotten you out on a stop loss order but if you would have held through the trade and let the probabilities work out you would have been a winner.
But if you used stop loss orders and said "okay if it touches 43" or whatever stop loss technique you use, you would have been out of the trade almost 42% of the time when you're making that type of entry.
Lets look at a different example here just to prove again the same concept. If you look at Netflix here at the time we're doing this video Netflix was trading at about 104.50. The probability of Netflix going up to and closing above the 120 strike in the May expiration was again, 20%.
So about a 20% chance that Netflix closed up above 120 between now and expiration. If you look at the probability of Netflix just trading up to 120 but not closing above, it's about 44%. So again about that 2 times probability of the Netflix stock touching our strike price at 120.
But there's only 20% chance that it stays up there. So to say it another way: every time that Netflix goes up and touches 120 half of the times when it touches 120 it will retreat and not stay up there, okay?
So when you are holding a paper loss that's hard to do. And what that means is that 44% of the time when you make this trade you're going to be holding a paper loss at some point between now and expiration. And that's hard to do for people.
They're going to be making a trade which on the outside has an 80% chance of success yet half of the time sometimes during expiration wether early or late in the cycle you're going to be holding a paper loss, and that's hard to do. Most traders see a paper loss, and they immediately want to get out of the trade.
But again, what if we used a stop loss order on say, that Netflix trade. What if we had sold the 120 strikes or sold a combination of a spread or something around there where our short strike was at 120. We know that that trade has an 80% chance of success. What would happen if we'd used a stop loss order?
Well, you're almost guaranteeing that you'll be closed out for a loss 44% of the time. Because 44% of the time you're going to be holding a losing trade of some sort. But yet when you entered the trade originally you had an 80% chance of success.
So a person who closes out the trade early loses guaranteed 44% of the time. The person who waits for all the way until to expiration lets the numbers play out wins 80% of the time. That's a huge difference. That's why we don't often favor using a lot of stop loss order.
So again like we just talked about, we do not believe in using stop loss orders on risk-defined option strategies such as the following because we know what the probabilities are and if we control our risk size then we don't need to do anything.
We can hold through a trade that becomes maybe a paper loss half way through the cycle because we know it's going to come back around, or half the time it's going to come back around. So we don't use stop loss orders in any way, shape, or form on credit spreads, iron condors, iron butterflies, debit spreads, or calenders.
Again the reason is that these trades are risked-defined. And what I mean by risk-defined is that we know how much money that we're risking for each and every trade. We can define our risk by doing a spread, okay?
So in this case, if you're placing trades on the right side of volatility, you're using small allocations which we talk about here at nausea. And you're doing it with the correct pricing, meaning you're taking in enough money to cover the risk then there's no need for a stop loss order ever.
Again, it's going to create more losing trades if you have a stop loss order in any way, shape, or form you put yourself at risk of getting closed out at the higher chance when the stock just happens to swing into one direction or another. And it's not just theory; this is fact here.
So we are fans, though (just to clear the water here) we are fans of having wide stop loss levels set on undefined-risk options strategies such as the following: strangles, straddles, single naked option positions.
We're not too naïve in assuming that there's no possible way that stop loss orders can not help a trader. But we want a limit using stop loss orders on a wide basis for straddles and strangles which have undefined-risk.
The reason that we want to use those wide strangles is that we know that we're going to get challenged on a trade. So we want to leave room in our stop loss order to be challenged on that trade. So again going back to the Netflix example. Let's say that we sold the 130 strikes which are down here.
These options have a 90% chance of being a winner. So a 10% chance that they're going to end in the money or the probability of being in the money is 10%. 90% chance that things are going to win at the end of the day if we just let them play out.
But there's a 22% chance that we're going to hold a losing trade at some point during the cycle. Does that mean it could be a dollar loser, could be a hundred dollar loser, could be 200 dollar loser?
We don't know what that's going to be, so we want to make our stop loss orders a little bit wider than normal so that we compensate and just recognize we're going to be challenged a little bit on some of the trades. But most of the time they're still going to be a winner. So we want to let the trades play out.
So if you look at our "When to Exit" guide, we have hard stop loss orders that are set for almost every strategy out there that's possible. Again, this is a free guide you can download here at Option Alpha.
Great little resource, but you see everything that is a risk-defined strategy call spreads, put spreads, calender spreads, butterflies, et cetera. There are no stop loss orders. You don't need to use a stop loss order on those because you can control your risk size on order entry.
You can manage the trade by getting into the right position and let the probabilities work out. As long as you're pricing these things correctly, you're never going to put yourself at a disadvantage.
Now when you do something like a custom naked spread or a single naked put, yes then there are some instances where you'll use a hard stop loss. In our case, we use somewhere between a 3 and 4X hard stop loss.
So what this means is that if for example ... going back to use just the Netflix example which is just fresh in our minds here. If we were to put in a trade and sell this Netflix 130 call $136, that's how much we could take in on it.
A 3X stop loss order on that would be buying this thing back when it reached a value of 408, okay? So if this thing went up in price up to 408, that's 3 times the initial credit that we received that's where we would say "okay, maybe the stock is making a really big move."
But notice how much room we leave in premium to fluctuate. I mean, we're leaving a couple of hundred dollars of fluctuation and premium there because of we now 90% of the time we're going to be winners.
We might be challenged early but we know as long as we keep these trades open, we price them correctly, we let the probabilities work out, 90% of the time or more we're going to be winners on these trades. So we're going to leave a little bit of fluctuation in there for this thing to move.
So again we also have guidelines for neutral trades. You'll see short strangles, short straddles, 3X hard stop loss of strategies that are risk-defined, balance on our Condor, other skewed iron condor, iron butterflies, no stop loss order.
And the same thing with bearish trades so all the risk-defined bearish trades do not have any stop loss order except for any undefined-risk trades like a naked call or a custom naked call spread, something like that, okay?
So here's the deal: you have to believe in the math, and you have to have the guts to hold on trades and let the numbers work out. It's always the consistent and persistent trader that wins long-term in this business.
And hopefully this video has been very helpful just to kind of enlighten you to the fact that most of the time when traders enter positions and use stop loss orders they end up actually creating more losing trades because the probability of stock just swinging during the month is much higher than the probability of a stock ending in a particular range or above or below a particular strike price.
So hopefully this has been helpful. Thank you so much for checking out this video. If you have any comments or questions or feedback, please let me know. Ask them in the comments section right below.
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