Option Credit Spreads - Where Should I Place The Stop Loss?
Posted by Pete Stolcers on October 5, 2011
Option Trading Question
I've lost 25 % of my account becasue I did not set a proper stop loss order during the big market decline last week. I'm confused on how to set a stop loss order and follow a good risk management rules. For example, if I establish a put option credit spread trade @ $1, should I place a buy-stop order to buy back the credit spread when it reaches $ 2 or $ 1.5 ? What type of option order do you place on the trading platform (trailing stop, stop limit order, order cancels other, conditional order)?
Option Trading Answer
I sell call credit spreads above a firm resistance level and put credit spreads below a firm support level.
The resistance level needs to be lower than the short call. Lets say that the stock has resistance at $53. I would sell the $55 - $60 call credit spread. If the stock rallies through resistance ($53), I’m still out of the money and I need to buy in the spread and take the loss. In this particular instance, I might set the stop at $55 just to make sure the breakout is not just a head fake.
The support level on a put credit spread needs to be above the short put strike. For instance, if the stock has support at $62, I would sell the 60 - 55 put credit spread. If support is violated ($62), I need to buy in the spread. The idea is that I have a resting point for the trade at that critical price level. Once it is breached, I know I was wrong on the trade. The credit spread concept is to take in $1 and not risk the entire $4. The strategy will work if your success rate is over 80% and you limit your losses. As a result, your stops need to prevent the short option from going deep in the money.
I like to use conditional orders. For example on a 60-55 put credit spread: Contingent on the stock $61 or lower, buy the 60 puts, sell the 55 puts - market. If you can estimate the price that the spread will be trading at, you can enter a limit. In the case of last week, you probably would not have been filled on a spread limit since the price moved right through.