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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.

Option Trading Comments

  • On 07/15, Reese Yorimoto said:

    "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”

    I think you meant to say sell the 60 puts and buy the 55 puts?

  • On 07/16, Pete Stolcers said:

    Hi Reese,

    My statement is correct. When you have a put credit spread you are short the higher strike price and long the lower strike price. Hence, you can collect a credit for it. When the stock has fallen below the support level, you have to take your losses and buy-in the spread. Hence, you are buying the 60 puts and selling the 55 puts.

    I hope this makes sense.

  • On 07/16, Pete Stolcers said:

    Hi Reese,

    The term long is synonymous with buy and the word short is synonymous with sell. We sold the $60 put and we bought the $55 put. We are short the 60 put and long the 55 put. You have to buy one strike and sell the other strike to create a spread. If I am buying both the 60 put and the 55 put, that is not a spread. It is two bearish positions.

    Yes, we sold the higher strike (60) and bought the lower strike (55). In order to unwind the position we have to do the opposite - buy the 60 put and sell the 55 put. 

    Now does it make sense?

  • On 07/17, Chrishonda said:

    I would like to know how to place stop losses on buying a call.  How do you determine what it needs to be? I’m new to options and that’s one of the areas I’m not clear on.  Thanks for any help!!

  • On 12/07, ed said:

    Hi Pete,
    Not one of your subscribers but continue to look at your site.  I think the easiest way to look at these spreads is......you buy the strike that gets YOU paid 1st or the most in a price move.

  • On 12/29, Lee Finberg said:

    like to put on credit spreads that expire the following month. When searching for underlying stocks for such put or call credit spreads, do you know of a way to locate those options with, say, February expirations?

    Thank you,

    Lee

  • On 12/29, Pete Stolcers said:

    Hi Lee,

    My process is always market, stock, then options. For instance, if I am market neutral but I really like the stock I will opt for an OTM put spread. The rationale is that the market could move lower and drag the stock down too. By distancing myself from the stock price, I give it room to move. If I were bullish on the market and the stock, I would buy a call.

    Right now I feel the market is treading on thin ice and put spreads are a good strategy. Find stocks that have held up well relative to the market (i.e. HMO’s) and sell OTM put spreads. If the stock breaks a support level, buy back the spread.

  • On 03/31, niamh said:

    Hi,
    Im new to options trading and bought a put today 3 strike prices out of the money.  Where and how should I place a stop loss? thanks

  • On 03/31, Pete Stolcers said:

    I have written a number of articles on stop loss placement. Please use the seach box on the home page and enter the words “stop loss”. This feature searches the archives and returns relevant articles.

    In short, if you are 3 strikes out, you have purchased a lottery ticket (unless it is an expensive stock/index). It will take a huge move to get that underlying in the money. Chances are you paid very little per option contract. In that case, you don’t need a stop. You are looking for a bi event and you don’t know when the underlying will explode.

    If by chance this does not describe the trade, the easy anser is to stop out when the stock does not behave as expected. Use major moving averages, trendlines and horizontal support and resistance levels as your guide.

    Good luck. Start slow and stay away form “pie in the sky” trades as you begin.

  • On 04/11, Daniel Wolf said:

    While Trading Options with currencies at 3-6+ month, I perfer to use stops, is this wise?  If you with the use of stops, please explain how i would properly due this with either puts and calls. Thank you, Dan

  • On 04/12, Pete Stolcers said:

    It is critical to have a game plan that includes exit strategies. I don’t like to assign fixed dollar or percentages to my stops because every asset and every situation is different. I use major trendlines, moving avereages and horizontal support/resistance as my guides. In essence, these breaches force me to admit when I am wrong and I have to exit the trade. I have written many articles on stops. Please use the search feature in my blog and enter keyword “stops”.

  • On 05/02, David said:

    Please provide the optimal size of the spread between the strike prices for use in a credit spread utilizing a fixed amount of margin. I trade SPX credit spreads and almost always offset the position prior to expiration. Usually a 50 point spread between the strike prices offers the highest return to risk. However, when I offset this position, the bid/offer cost eats up so much of the return that it appears that a larger spread between strike prices (75 or 100 points) produces the highest percentage return to risk. For instance, if I trade a 1300/1250 put credit spread and offset this position, it appears that the return to risk is greater in a 1300/1200 put credit spread. Any insight would be appreciated.

  • On 03/02, igor said:

    Hi Pete,

    I have a question about trailing stop order.
    I currently own a PBI - bought APR 20/17.5 Bear Put spread with 46 days until exp. date

    I can see a partial unrealized profit right now.
    Do you think I can enter a trailing stop order on that position or itís too early to make this move.
    What is your philosophy on this?

    Thanks

  • On 03/10, Jay said:

    Hello,

    If I place a BULL PUT SPREAD and then SOLD leg becomes ITM and the LONG leg is OTM. Then what can happen if the SHORT option has only intrinsic value left?? Assuming I dont close the position;

    1. Can my broker assign the stock to me?
    2. Or will my broker recoganise the trade as a Vertical Spread trade and close the spread for me and avoid assignment.

    Kindly assist.

  • On 03/10, Pete Stolcers said:

    If you are short an in the money put - YOU WILL BE ASSIGNED.

    Auto-exercise/assignment is handled by the options Clearing Corp (OCC) and I believe $.05 is the cut-off.

    If your long put is in the moeny, it will be auto-exercised on your behalf. The difference between the strike prices less the credit you put the spread on for will be your loss on the trade.

    If your long put is out of the money, you will come in the next week long shares of stock. if you sell the shares that first day, you will not have to put up long stock margin (same day substitution).

    In general, I do not like letting a put spread go more than $2 ITM before closing the trade down. You have to recognize when you are on the wrong side of the trade. I know that sometimes the stock gaps and you can’t help it, but the scenario you outline should be the exception.

  • On 03/11, Jay said:

    Hi Pete,

    Thank you very much for the detailed and prompt reply.

    Is there any way to instruct the broker to perform a “same day substitution” should the above scenario arise.

    Kindly advice.

    Thanks
    Jay

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