Do you set stop limits on your option trades or trailing stops? In the stock splits newsletter, when you highlight a stock, you mention a reasonable stop limit. How do you determine the stop limit for the option? Do you go through the delta calculation? (February 7, 2004)
The stock price is the major influence on the underlying option's movement, so typically we use the stock's price to determine when we buy and sell. If a stock holds support, then that is good for the option because the stock typically rebounds from there and the option price does the same. Therefore, when the stock hits a stop point, that is generally a sell on the option position. That requires just watching the stock and then acting with the option accordingly, and, of course, the percentage loss on the option would be greater than the stock as the option's move is magnified compared to the stock. We are usually content to let our options work along with the stock price as long as we have sufficient time left before the option expires. Remember, 60 days out you are okay, but time starts to become a factor the closer you get to 30 days out from expiration. Thirty days or less, time becomes very important.
If you are more interested in putting a stop on the option itself as opposed to watching the stock, you can calculate the what the value of the option will be when the stock hits a certain price. You use the option's delta to do this. This way you can put in a stop order (stop loss or stop limit) directly on the option position as opposed to having to watch the stock. We will often do this when we have a good gain built into the option that we want to keep regardless of what the stock is doing. Many times we will have a 50+% gain on our option position even before the stock hits the target. With time value as our enemy on options we buy, we don't want to lose that gain if the stock decides to make a test.
To make the calculation with respect to a stop point, subtract the stock price that you bought at from the stock price that is the stop loss point. Multiply that result by the option's delta. The result of that calculation will tell you how far the option will move given the stock move to the stop point. Subtract that amount from the bid price at the time you entered the play and that will give you the bid price for the option at the stop point. To determine the target, you do the same calculation with respect to the target stock price, but you add the result to the bid price to get the figure out the dollar move the option will make by the time the stock hits the target.
Formula for calculating option target price on an upside play:
(Stock target price - Stock buy price) x option delta + option bid price = option bid price when stock hits target price.
Formula for calculating option stop loss price on upside play:
(Stock buy price - Stop loss price) x option delta + option bid price = option bid price when stock falls to stop loss point.
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