Pro tip: Never use stop-losses when trading options.
Just don’t do it.
It’s not a pet peeve of mine, just bad practice.
A stop-loss is an order you can place with your broker ahead of time, letting them know the price you wish to sell at if it falls to that level. Once it falls to that price, you’re ready to exit the trade so that you can preserve capital in case it’s set to fall even further.
When you’re trading highly liquid stocks, stop-losses can work. They’re a great way to help you sleep at night and understand your risk level.
And it’s the smart thing to do when it comes to investing: Manage your risk.
But when it comes to options, there are many reasons why you would never want to use a stop-loss.
Today, I’ll walk you through why I avoid them like the plague in options trading.
And I can show you using our open recommendation in Qualcomm (Nasdaq: QCOM).
We Didn’t Want to Exit Qualcomm
At the beginning of November, I sent out the recommendation to add call options on Qualcomm, just to give you a taste of how options trade in real time.
We followed my Quick Hit Profits strategy of buying call options on a company after they reported earnings and hit my Profit Trigger.
But on the third day of our position, just two days after I recommended the call options, the stock experienced a gap lower.
A gap is the change from the close price to the next morning’s open price.
The stock closed at $142.61 on November 9, and opened the next morning at $140.15 — a mere 1.7% gap lower in the stock.
Here’s the problem: Options can see a much larger move than that.
Even though the stock opened just 1.7% lower, the option was down 18%. Our position had fallen roughly 40% in just three days.
Remember, a stop-loss is an order saying that you want to exit your position if it falls to that price or lower. “Or lower” is the key here.
Because the market makers see that someone wants to sell at that stop price. And they have the ability to push option prices to those levels when it is reasonable, like the quick drop we saw in our Qualcomm call options.
While you may think you have a tight 20% stop-loss on the option and are only risking 20%, if the option price gaps lower — even by a mere 18% — your orders could be filled for a 40% loss … or even worse.
That dramatic difference basically makes using stop-losses on options pointless.
That move would have easily hit almost everyone’s stop-loss if you had one, unless it was an extremely low stop-loss — like 75% or more.
But the most important part is what happened over the next few days. The option price swung back higher to a profit of nearly 40% at its peak.
A wild turn of events that you would have missed out on if you used stop-losses.
Follow a Profitable Strategy while trading options
That’s the main reason I avoid using stop-losses when trading options.
Instead, I prefer to follow a proven approach that’s designed to generate profits, even accounting for the occasional loss. Then you’ll have a better idea on when to exit, and not base it on some random rule.
Let me give you an example…
A trade I recommended on Qualcomm last year was down more than 40% at one point. It swung back over the next few weeks to deliver us peak gains of 133% in 51 days. Had we preserved capital when things were heading south, we would have never been handed that triple-digit opportunity.
Here’s the thing with options … The most you can lose is 100%. That’s a total loss of what you spent on the option.
It sounds harsh to lose that much, and it is painful to take a loss of that amount.
But it’s why you should never risk more than you can stand to lose.
Because even though your losses are limited to the capital you spent on the trade, your gains can run much, much higher. You can see gains of more than 100%, 200% and even 500% in a few short months.
If you hit more wins than losses and see bigger wins than losses, you are going to make money over time. That’s the key.
And it’s the No. 1 goal behind every strategy I develop.
If you don’t have a profitable options strategy to follow yet, learn option strategies with Sachin Sival. We’ve created a one-of-a-kind opportunity to get started with some option hedging strategies to earn with limited risk.
We’ll be back next week with more options education for you.
This content was originally published here.