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April 24, 2014

Stop Loss or Trailing Stop?

The market has moved higher, lower and higher again over the last month or so. Even though the market has rallied as of late, there’s still a potential for the market to move lower. Regardless, whether the market continues to move higher or lower once again it is always a good time to talk about stop losses. Traders may hear the terms trailing stop loss and stop loss order and wonder exactly what those terms mean and how a stop loss can potentailly enhance a trading strategy. Well, worry no more because that is exactly what we will review in this blog entry. To get more educational ideas like this, sign up for a free two-week trial of Market Taker Mentoring’s options newsletter.

Let’s start with the basics which is defining a stop loss order. Basically, a trader will tell the broker a certain price on a stock (or option) where the position will be closed; but it’s a little different than a typical closing order. For longs, the closing price is below the current market price and for shorts the stop loss closing order is above the current market. Let’s take a look.

Stop Loss Example

A trader could purchase a stock for $20.00 and set a stop-loss order at $18.50. This means that the position will be closed at the market price once the stock drops below $18.50, pretty simple right? It is called a stop loss order because it stops the trader from taking any more losses. Many traders use a set percentage of a trade for a stop loss order. If a trader wants to use a stop loss order for an option, the bid and ask prices would be monitored and then the same decisions as were made in the stock example are followed.

Trailing Stop Loss Example

A trader chooses a lower target price to keep losses in check and tells the broker to sell the contract once this price is violated. There is another stop loss strategy, the trailing stop loss. A trailing stop loss is either a fixed percentage or a fixed nominal increment from the current market price. Once the market price moves away from the stop, the stop moves, or trails, the market. It remains in place, though, if the market moves towards it.

Once the trailing stop loss is triggered the stock is sold, just like the regular stop loss. The benefit of the trailing stop loss is that it is flexible. If you purchase an option for $10 and set a trailing stop of 50 cents, the sell target is $9.50. Of course, as the stock increases in value, the 50-cent trailing stop will do follow (the stock trades at $10.50, the trailing stop becomes $10.00).

A trailing stop loss can be used very effectively in profit taking and it is a strategy I have used often myself. Let’s revisit the $10 stock with a 50-cent stop loss. If the company reports blow-out earnings, driving the price sharply higher, it might be time to adjust the trailing stop loss. In this example, let’s say the stock jumped to $12.00. A nice profit, but there could be some more room to the upside. Maybe the trader will adjust that trailing stop a little tighter to, say, 25 cents. Doing so allows the trader to lock in a profit of at least 1.75 (12 minus 10 = 2, 2 minus 0.25 = 1.75).

Consider the option next time you are in a profitable position!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 6, 2011

Analyzing Options With Volume and Open Interest

Volume and open interest are two very important options data that can help traders understand what is going on in the options market. it is an important part of any trader’s options education. Volume and open interest helps traders make better decisions, and can make them more profitable traders. But to be able to use volume and open interest data, traders must understand exactly what each represents. Let’s take a close look at volume and open interest.

Volume and Open Interest

Volume and open interest are two distinctly different things. Volume is the number of contracts traded in a day. Each day volume starts over at zero. Open interest is the number of contracts that have been created—that are open. Open interest is an on-going, running total.

Volume and Open interest Example

Imagine it is the day after expiration and a new contract month, the November expiration cycle, is listed for option class XYZ. A trader, Retail Joe, logs into his online retail trading account from home. Retail Joe enters a buy order to buy 10 November 65 calls. The order is routed to the exchange and executes with Mark Etmaker, a market maker on one of the U.S. options exchanges.

Because this is the first day these contracts were made available to trade, open interest was zero at the start of the day. Volume is always zero at the start of the day. After the trade is made, both open interest and volume increased: Retail Joe is long 10, and on the other side of the trade, Mark Etmaker is short 10. Therefore:

Volume: 10

Open interest: 10

Now imagine that later that day, a third party trades in the November 65 call series. Tina Trader decides to sell 10 calls (maybe as part of a covered call). It just so happens that Mark Etmaker is the market maker who buys the calls from Tina. Notice what happens with volume and open interest.

Volume: 20

Open interest: 10

Because the trade happened the same day, the trade increases volume by the number of contracts traded. But a new contract wasn’t created; it just changed hands. Now, the two parties to the call are Joe and Tina; Mark Etmaker is flat. Therefore, open interest remains the same.

The next morning, volume and open interest is:

Volume: 0

Open interest: 10

Volume starts anew and open interest continues on.

Now, imagine that (coincidentally) Joe decides to sell the 10-lot to close and Tina just so happens to buy hers back at the same time; they trade with each other. Now, both Joe and Tina have no calls—they are flat. Now volume and open interest is:

Volume: 10

Open interest: 0

Ten contracts changed hands; so volume is 10. And the existing contract was closed; so open interest is zero.