By Chris Ebert

stop oders signIt has been reported that the NYSE will discontinue certain types of orders for stocks known as Stop orders and GTC orders (Good Till Cancelled) beginning February 16, 2016.

The rationale behind the move likely stems from financial damage suffered by many traders, particularly retail traders, during wild moves in stock prices. During events such as the Flash Crash of 2010 and, more recently, the sell-off of August 24, 2015 some traders using Stop orders and GTC orders were exposed to potentially large losses. In theory, some of those losses might have been avoided or at least mitigated had they not used those particular order types.

The Stop order is often used as a method for limiting losses on a trade when the stock price moves unfavorably. For example, a trader who buys 100 shares of stock at $100 can set a Stop at $90. If for some reason the stock price later falls below $90 the shares would be sold automatically. By selling the stock automatically, the trader can usually avoid larger losses, for example if the stock price were to fall to $80.

Problems with Stop Orders

The problem with Stop orders is that they are not always filled at the Stop price. For example, a trader who sets a Stop at $90 might find the trade filled at $80 in a wild downturn such as the event of August 24, 2015. The reason for the discrepancy is that the Stop price only acts as a trigger; it does not guarantee the actual price at which the order will be filled. The actual trade price will depend on whether the order is a Market-price Stop order or a Limit-price Stop order – each order type having its own risks.

When a Stop is used with a Market-price order, the trade may execute at a price far lower than the Stop price. For example, if the Stop price is $90 and the stock price falls below $90 it will trigger an order to sell the stock to the highest bidder (at Market price). In an event such as the one this past August, overnight panic can result in a lack of bidders when the market opens for trading the following day. If the highest bid is $80 the trader with a Market-price order might have that order filled at $80, despite the fact that the Stop price was set at $90. Panics can occur during regular trading hours as well as overnight, as was the case in the Flash Crash of 2010, therefore all Stop orders – Day Stop orders as well as GTC Stop orders – are at risk.

The trader with a Limit-price order is not immune to the risks of using a Stop order. A Limit order guarantees the price at which the trade will execute, but it does not guarantee an execution. So, for example, a trader might wake up and find the stock price has declined to $80 and the shares were not sold – the trader still owns the shares (at a significant unrealized loss). Once the $90 Stop was tripped, the order to sell became a Limit-price order at $90; and since there were no bidders willing to pay $90 the order to sell went unfilled. Whether a panic occurs overnight or whether during normal trading hours, the Stop Limit order may be virtually useless at limiting losses.

Problems with GTC Orders

In a similar manner, GTC orders are especially prone to affecting traders negatively when the market makes wild moves. Just as Stop orders can execute at prices far from the Stop price or not execute at all, GTC orders also carry such a risk. GTC orders by definition are Good Till Cancelled, which means they are generally left open overnight. This is a contrast to Day orders which expire at the end of the day’s trading.panic button

While Day orders are not without the risk of being filled at a price that differs greatly from the price entered (in a Market-price order) or not being filled at all (in a Limit-price order) – either of which could result in a significant or even catastrophic loss – the risk tends to be much greater with GTC orders. The reason being, GTC orders will remain open overnight and thus be subject to overnight panics that occur outside of trading hours. When the market opens the following day, the trader with an open GTC order may have no control over the trade, which may either execute at a horrifically poor price or else leave the trader holding the stock at a truly horrific price.

Panics can and do occur at hours of the day when the market is open, thus affecting all traders and all order types – Day orders as well as GTC orders. But in such daytime events both the Day order and the GTC order are on equal footing. Neither trade type is at a particular advantage or disadvantage compared to the other. On the other hand, GTC orders are at a distinct disadvantage when it comes to overnight panics because of the lack of control the trader will experience when the market opens the following day.

Benefits of Stop and GTC Orders

In either case, whether using a Stop order or a GTC order, there is nothing inherently wrong with the order type itself. To the contrary, each of those order types can be very valuable and save a trader from significant losses. Indeed, many traders have been rescued from potential financial ruin through the use of Stop and GTC orders.

The problem with these order types is that they sometimes present the risks outlined above. Since individual retail traders may not understand all the risks, those same traders are the most likely to suffer unexpected financial damage during wild market moves. The savvy trader who understands the risk will suffer the same loss as the unwitting trader. But, the savvy trader, knowing the risk ahead of time, is more likely to be prepared to handle it. The unwitting trader could conceivably wipe out an entire life’s savings in one day by taking on more risk than he or she knew was being taken.

The elimination of Stop orders and GTC orders for all traders will eliminate the hidden risk for uninformed individual retail traders. Nevertheless, since many traders have come to embrace such order types, there is a need to find replacements for them once they are eliminated.

Option Alternatives to Stop Loss Orders

insuredStock options may offer a suitable replacement for many traders. In some cases, stock and equity traders may actually find options to be a better alternative than either the Stop order or the GTC order.

The most common order is likely the Stop order used to limit losses on shares of stock that are owned or shares that have been shorted – also known as the Stop Loss order. Either a Protective Put option or a Married Put option can be used as a suitable replacement for a Stop Loss order on a long stock position. In a similar manner, a Protective Call option or a Married Call option can be used as a replacement for a Stop Loss on a short stock position.

  • Example 1
    A trader owns 100 shares of XYZ stock which is trading at $100 per share and wishes to place a Stop Loss order at $90 per share. Buying a single XYZ Put option at the $90 strike price will guarantee the sale price of those 100 shares will be no less than $90. The guarantee is valid under all circumstances, even when the market experiences wild moves and even during events such as a flash crash. The sale price is guaranteed until the expiration date of the option. Here the option is known as a Protective Put, which may serve as a suitable replacement for a Stop Loss order on a long stock position.
  • Example 2
    A trader has shorted 100 shares of XYZ stock which is trading at $100 per share and wishes to place a Stop Loss order at $110 per share. Buying a single XYZ Call option at the $110 strike price will guarantee the buy-to-cover price of those 100 shares will be no higher than $110. Again the guarantee is valid in all circumstances, until the expiration date of the option. Here the option is known as a Protective Call and may serve as a suitable replacement for a Stop Loss order on a short stock position.

In each of those examples the strike price of the option is the same as, or as close as possible, to the Stop price the trader would have used in a Stop order. The choice of expiration date of the option can depend on many factors, such as the length of time the trader intends to keep the stock position.

Options can be expensive, so it is important for the trader using options as an alternative to Stop orders to consider the cost of the option as well as the amount of time the option will be needed. While there is no one-size-fits-all for options, a good starting place for new option traders may be to consider matching the expiration date to the intended time frame for the stock trade.

For example, if the stock will likely be held through March, then using a March expiration date for the option may make sense; that way the stock is protected for the entire life expectancy of the trade. The best choice of expiration date can vary greatly though, so it behooves a trader to study factors that are unique to options, such as time-decay, before replacing Stop orders with protective stock options.

Options for Buy On Stop and Sell On Stop

Perhaps not as common as Stop Loss orders, which are primarily used to exit a position, Buy On Stop orders and Sell On Stop orders are generally used to initiate a stock position. A Buy On Stop order is generally used as a means of buying shares when the stock rises above a pre-determined price – the Stop price. A Sell On Stop order is generally used to sell shares short when the stock price falls below the Stop price.Lottery

The Buy On Stop order can be simulated using a Long Call option. A single Long Call option will allow a trader to buy 100 shares of stock at a pre-determined price. The Sell On Stop Order can be simulated using a Long Put option. The Long Put option will allow the trader to short 100 shares of stock at a pre-determined price. In each case, the pre-determined price is the strike price of the option.

  • Example 3
    A trader wants to buy 100 shares of XYZ if it rises to $110 per share using a Buy On Stop order, and it is currently trading at $100 per share. The trader can buy a single Call option at the $110 strike price and the trader will then have the right to purchase 100 shares of XYZ at $110. That right could come in quite handy if, say for example, the stock price rises to $120 per share. As with all options, the expiration date is important, but a trader may want to consider an expiration date that matches the intended holding time for the stock. Here, the Long Call option simulates the result of the Buy On Stop order.
  • Example 4
    A trader wants to short 100 shares of XYZ if it falls below $90 per share using a Sell On Stop order, and it is currently trading at $100 per share. The trader can buy a single Put option at the $90 strike price and the trader will then have the right to sell short 100 shares of XYZ at $90. That right could come in quite handy if XYZ was to fall to $80 per share. Here, the Long Put option simulates the result of the Sell On Stop Order.

Options for GTC Orders

Just as options can be used to simulate the effects of a Stop order, they can also be used as an alternative to GTC orders. For GTC orders that are being used as a means to exit a trade, a trader can often use one of the options in the examples above for Stop Loss orders.

dollarFor GTC orders that are being used for an entry into a stock position, a trader can often use one of the options in the examples above for Buy On Stop or Sell On Stop orders. However, since Buy On Stop and Sell On Stop orders only apply to a stock moving in a specific direction – Buy On Stop for buying shares when the stock price is rising, Sell on Stop for shorting shares when the stock price is falling – a trader may not find a good alternative using the above examples.

There are occasions when a trader will desire to enter a GTC order to buy shares of stock when the share price is declining. Typically this is done with a GTC Buy Limit order, in which the Limit price is below the current share price. Conversely, a GTC Sell Limit order can be entered to short shares, in which the Limit price is above the current share price. Although options may not offer an ideal alternative for such scenarios, there are some options that may prove suitable.

  • Example 5
    A trader wishes to enter a GTC Buy Limit order to purchase 100 shares of XYZ at $90 when XYZ is trading at $100. The trader can instead sell a single XYZ Naked Put option at the $90 strike price. Should the stock price fall below $90 the option will likely be assigned and the trader will buy 100 shares of XYZ at $90. This is not an ideal alternative because it only simulates the GTC Buy Limit order if the option is actually assigned, and assignment is completely out of the Naked Put seller’s control. The option will usually only be exercised and assigned if it is in-the-money near expiration day (if the share price is below the strike price the option is considered in-the-money). For that reason, it may be worth considering using the nearest available expiration date. Many options have weekly expirations, so they may work well as an alternative to GTC Buy Limit orders. The shorter the time to expiration, the less time exists for the stock price to reverse or retrace any moves, thus the greater the chance that the option will be assigned if the stock’s share price falls below the strike price of the option. Even so, if the stock price rises above the strike price of the option prior to expiration day, the option might never get exercised or assigned, and the Naked Put seller will miss out on the gains in the stock. In a case in which no assignment occurs, the Naked Put Seller will keep the option premium as a profit. If the option does expire without being assigned, the trader must re-enter a new Naked Put to continue simulating the GTC order.
  • Example 6
    A trader wishes to enter a GTC Sell Limit order for 100 shares of XYZ at $110 when XYZ is trading at $100. The trader can instead sell a single XYZ Naked Call option at the $110 strike price. Should the stock price exceed $110 the option will likely be assigned and the trader will sell short 100 shares of XYZ. Again, the Naked Call is not an ideal alternative because there is a chance the option may not be assigned. But, by using the nearest possible expiration date the trader can increase the odds of being assigned because there will be less time for the stock price to reverse direction prior to expiration day. Thus the Naked Call option with a very near expiration date may serve as an alternative to the GTC Sell Limit order. If the option does expire without being assigned, the trader must re-enter a new Naked Call to continue simulating the GTC order. As with any Naked option, if the option does indeed expire worthless, without being assigned,  the trader who sold the Naked Call will keep the option premium as a profit, so that’s always some consolation.

To summarize:

  1. Long Put options simulate Stop Loss orders to exit long stock positions.
  2. Long Call options simulate Stop Loss orders to exit short stock positions.
  3. Long Call options simulate Buy On Stop orders to enter long stock positions.
  4. Long Put options simulate Sell On Stop orders to enter short stock positions.
  5. Naked Put options with near expiration simulate GTC Buy Limit orders to enter long stock positions.
  6. Naked Call options with near expiration simulate GTC Sell Limit orders to enter short stock positions.

The options positions are simulations, not exact duplicates of the stock orders. In some cases the options may perform worse than the respective stock order; in some cases better. In any case, options are worth careful consideration now that those order types may soon no longer be available.

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

 

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