Tactics Series-Stop Losses

BASIC

Stop Losses

Stop loss orders can help manage a position’s profits and losses

By Kai Zeng & Michael Gough

Not many traders have the time to monitor their portfolios constantly and close positions when the market moves against them. So what can they do to prevent the detrimental effects of an outsized move on a position’s profit and loss (P&L)?

They can manage trades with the help of the stop-loss order—a standing order that closes the trade when the losses in a position exceed a predefined amount. This type of closing order allows traders to rest easy knowing that if they step away from the screen, their losses won’t exceed a certain dollar figure if the underlying experiences a black swan event.

Stop-loss orders have gained great popularity with stock traders because of the outsized moves in single name equities. But what prevents options traders from using these orders? After all, naked short options can assume large losses because of their inherent leverage.

Let’s compare the performance of two short options management strategies. In the first case, the short options are simply held to expiration. In the second, the short options are managed when losses equal the amount of the credit initially received, just like a stop loss. For example, if the option is sold for $1, the stop-loss order kicks in when the option is trading for $2. The parameters of the back-test are as follows:

Data Date: 2005 through 2019 Underlying Asset: SPY Option Delta: 50 (At-the-Money) Approximate Days to Expiration: 30 Number of Occurrences: 3,400

Using 15 years of data in this backtest makes it possible to incorporate lots of market events, including the Great Recession, Flash Crash and Post-Election Rally. SPY is used as the underlying security because of its deep liquidity, robust options markets and depth of market data. The 50-delta put option is used because it is a higher probability trade with a lower buying power requirement than buying and holding stock. Additionally, the short put generates positive theta decay.

The first question is whether stop losses effectively reduce large losses for options sellers. As seen in “Stop It,” right, incorporating a stop loss can reduce large losses! Compared to holding to expiration, using a stop loss reduces losers by 42%. Does that imply traders should incorporate stop losses for all of their trades? No, traders should also consider profitability.

Stop It

Compared to holding to expiration, using a stop loss reduces losers by 42%.

50 Delta SPY Puts/NoStopLoss/1x Stop Loss/ Improvement Largest Loss/ -$2,822/-$1,630/42%

Although stop losses can help traders sleep well during a market meltdown by limited losses, their overall performance is worse than holding to expiration, as seen in “Limiting Losses,” right. Using a stop loss resulted in a lower win rate and a lower average P&L. Although not included here, these performance trends persist across varying assets and different delta put options.

Limiting Losses

Using a stop loss resulted in a lower win rate and a lower average profit and loss.

50 Delta SPY Puts/No Stop Loss/2x Stop Loss Win Rate/75%/65% Average P&L/$63/$40

While options traders can limit losses with stop-loss orders they should be aware of the potential lower average P&L and win rate. As with most trading decisions, there are trade-offs. If traders prioritize mitigating losses, they can use stop losses. However, if per-trade P&L becomes the priority, they may want to consider other management techniques.

Kai Zeng, an active derivatives trader for more than 10 years, works as a data scientist and derivatives strategist at tasytrade. Michael Gough, a self-taught coder who became an options trader, serves as co-host of tastytrade’s Research Specials Live.

INTERMEDIATE

Stop Profits

Yes. It’s a thing. Traders can limit the potential for large losses while maintaining, and even improving, profitability

By Kai Zeng & Michael Gough

What’s more important: trade entry or trade exit? As experienced traders know, both are integral to a trader’s profits!

Stop Losses, the Basic Tactics article in this issue on page 59, tests the viability of incorporating stop losses into short option trades to limit large losses. This management strategy successfully reduces large losses; but it also reduces the profitability and win rate of short puts. Can traders do anything to limit the potential for large losses while maintaining or improving profitability?

How about a stop profit management strategy—the opposite of a stop loss? Instead of closing trades based on a loss amount, it closes trades at a pre-defined profit level.

Options traders can use this strategy seamlessly because max profits are defined at trade entry. A put option sold for $500 can never make more than $500, thus a profit-taking strategy can be set as a percentage of the potential max profit. For example, a 50% stop profit on a put sold for $500 would execute when the profit is $250.

Using the back-testing framework from “Stop Losses,” let’s compare the performance of holding the short puts to expiration, incorporating a 1x stop loss and managing at 50% of the potential max profit. The back-testing framework is as follows:

Data Date: 2005 through 2019 Underlying Asset: SPY Approximate Option Delta: 50 (At-the-Money) Approximate Days to Expiration: 30 Managed Short Puts at 50% Potential Max Profit Number of Occurrences: 3,400

Taking money off the table improves profits and reduces risk

As seen in “The Results,” (pg. 61) managing short puts at 50% of the potential max profit greatly improves the win rate by locking in small winners before they turn into losers. But trading isn’t all about win rates. Win rates can be misleading if large losses wipe out the gains of small winners. It’s important to also consider profitability. One way to measure profitability is annualized return on capital (ROC). Annualized ROC explains how much return a trader can expect to make for a given amount of capital deployed and normalizes based on differences in trade duration.

The Results

Managing short puts at 50% of the potential max profit greatly improves the win rate by locking in small winners before they turn into losers.

50 Delta SPY Puts/Held to Expiration/Stop Loss/Profit-Taking/ Win Rate/75%/65%/85%

As seen in “Best ROC” (pg. 61), managing short puts at 50% of the potential max profit provides the greatest annualized ROC. Wait a minute, some may suggest. How can the strategy that “leaves money on the table” provide the greatest ROC? Managing at 50% of the potential max profit yields the greatest ROC because of the high number of winning trades and the reduced trade duration, which prevents profitable trades from turning unprofitable before expiration.

Best ROC

Managing short puts at 50% of the potential max profit provides the greatest annualized ROC.

50 Delta SPY Puts/Held to Expiration/Stop Loss/Profit-Taking Win Rate/75%/65%/85%

Because stop losses prevent large losers and profit taking increases annualized ROC, is it viable to incorporate both management strategies?

The table “Managing Losers & Winners,” right, combines stop losses and the profit-taking results in the best performance and compares them to holding short puts to expiration. Managing both losers and winners improves profitability, maintains the same win rate and reduces large losers. Although seemingly counterintuitive, taking money off the table improves profits and reduces risk.

Managing Losers & Winners

Managing both losers and winners improves profitability, maintains the same win rate and reduces large losers.

50 Delta SPY Puts/Held to Expiration/Stop Loss & Profit Taking Annualized ROC/24%/30% Win Rate/75%/75% . Largest Loss/-$2,822/-$1,630

Profitable trading demands attention to both entry and exit. The cumulative results of a portfolio employing these strategies can be seen in “Outperformer,” right, which shows that the portfolio incorporating stop losses and profit taking outperforms the portfolio that only incorporates stop losses. Although contradictory to the conventional financial advice of letting profits run, an active profit-taking strategy in conjunction with stop losses greatly improve a portfolio’s risk and return profile.

Outperformer

A portfolio incorporating stop losses and profit-taking outperforms the portfolio that only incorporates stop losses.

Counterintuitively, traders tend to come out ahead by using the stop profit, which closes trades when they reach a predetermined level of profit.

Kai Zeng, an active derivatives trader for more than 10 years, works as a data scientist and derivatives strategist at tasytrade. Michael Gough, a self-taught coder who became an options trader, serves as co-host of tastytrade’s Research Specials Live.

ADVANCED

Fine-Tuning Stop Losses

Parts I and II in this series made the case for stop losses in options trading … and stop profits. To use stops well, it’s critical to understand how to determine the optimal stop-loss level

By Kai Zeng

In this issue of luckbox, the Tactics section explores stop losses. The Basic article, Stop Losses (pg. 59), tests using stop losses in short option trades, and the intermediate article, Stop Profits (Pg. 60), tests the performance of incorporating both stop losses and active management into a short options portfolio. The studies indicate that combining stop losses and profit taking tends to pay off by yielding greater average P&L and controlling large losses. Let’s take that research a step further by testing the performance of varying stop loss levels.

The level of the stop loss can have a big impact on a portfolio’s performance, so this study will test a variety of stop losses. These types of stop losses are defined as tight and loose and each has pros and cons. Tight stop losses allow for only small losses, which results in lower portfolio volatility. Loose stop losses, on the other hand, may experience large losses but also give the trade more time to bounce back and become profitable, resulting in a higher win rate. Which strategy’s better?

Let’s test the performance of varying stop losses by using the same back-testing framework used in the Basic and Intermediate articles of this Tactics series.

Data Date: 2005 through 2019 Underlying Asset: SPY Approximate Option Delta: 50 (At-the-Money) Approximate Days to Expiration: 30 Managed Short Puts at 50% Potential Max Profit Managed Tight Stop Losses at 25%, 50% and 75% of the Premium Received Managed Loose Stop Losses at 100%, 200% and 300% of the Premium Received Number of Occurrences: 3,400

Tight stop losses mean that if the original short put collects $5 in credit and the max profit is $500, the stop loss will kick in when the losses reach $125, $250 and $375, respectively. Loose stop losses mean that the same short put will close when losses reach $500, $1,000 and $1,500, respectively.

As in the previous two studies, this analysis examines the annualized return on capital (ROC), win rate and largest loss of each management strategy. The annualized ROC explains how much return a trader can expect to make for a given amount of capital deployed. Win rate describes the portion of trades that were profitable, and the largest loss is a measure of risk that highlights the worst performing trade’s P&L.

When managing losses at 25% of the option price, the probability of being profitable is only 42%—worse than the odds at a casino roulette table.

As seen in “Stop-Loss Performance,” (pg. 62) all of the stop losses reduced the largest loss when compared to holding the trade to expiration. This shouldn’t be much of a surprise. More surprising, however, are the changes in the ROC and the win rate. Although incorporating stop losses reduced the largest losses when compared to holding to expiration, it did so at the expense of a lower ROC and win rate. The tighter the loss control, the lower the win rate. This matches the original assumption that looser stop losses allow more time for trades to become profitable.

Stop Loss Performance

All of the stop losses reduced the largest loss when compared to holding the trade to expiration. This shouldn’t be much of a surprise. Note: The largest loss numbers are the same for tight control targets because the database uses end-of-day data.

When managing losses at 25% of the option price, the probability of being profitable is only 42%—worse than the odds at a casino roulette table. Additionally, the ROC is worse than holding the trade to expiration when traders don’t apply any management! On the other hand, the loose stop loss at 300% only marginally reduces the largest loss but sacrifices 300 basis points in the ROC. There is a clear dilemma in using these stop losses:

-Tightening the stop loss increases the number of the unprofitable trades, which directly hurts the annualized ROC. -Loosening the stop loss increases the win rate and ROC but ultimately defeats the point of incorporating a stop loss because losses are similar to just holding to expiration.

The analysis in the Intermediate article, Stop Profits (pg. 60), of this series indicates that to achieve greater performance it’s important not only to manage losses but also to manage winning trades proactively. How might the performance change for these tight and loose stop losses if a trader also incorporates a profit-taking strategy? In this piece, profits will be managed at 50%. For example, a short put sold for $5 will be closed when the profits are $250.

As seen in “Stop Loss with Profit Taking Performance” (pg. 62), adding a proactive profit-taking strategy drastically improves the performance of all six management strategies. Managing losers and winners has a positive impact on both the annualized ROC and the win rate.

Stop Loss with Profit Taking Performance

Adding a proactive profit-taking strategy drastically improves the performance of all six strategies.

These performances can be evaluated by comparing the long-term portfolio performance of each strategy. This performance is evaluated by holding one contract continuously since 2005.

As seen in “Tight Stop Loss Performance,” left, the combination portfolio of managing tight losers and winners provides a greater cumulative portfolio performance than just managing losers, no matter the stop-loss amount.

Tight Stop Loss Performance

The combination portfolio of managing tight losers and winners provides a greater cumulative portfolio performance than just managing losers no matter the stop-loss amount.

The same trend persists for loose stop losses; incorporating active loss and profit management results in greater cumulative performance. (See “Loose Stop-Loss Performance,” left.)

Loose Stop Loss Performance

Incorporating active loss and profit management results in greater cumulative performance.

Adding a profit-taking component to stop losses results in consistently greater performance in the long run. Additionally, comparing the two types of stop losses, tight and loose, one sees that looser stop losses result in greater cumulative performance than their narrow counterparts.

Kai Zeng, an active derivatives trader for more than 10 years, works as a data scientist and derivatives strategist at tasytrade.