One of Warren Buffet’s most famous sayings regarding successful investing is, “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”

That means risk management needs to be the priority of every position or investment.  The two main tools traders use to limit losses are appropriate position-sizing and designating specific levels at which a trade will be closed.  

When trading stock, one of the most popular methods is to establish a stop-loss order. This is a type of order that will trigger, typically a sale, but can also be used to buy cover stock sold short if the shares hit a specified price. 

For example, let’s say own 300 shares of Apple (AAPL) in which your cost basis is $220 per share.  With the currently trading around $245 and you want to insure that the position remains profitable you could set a stop-loss order to sell the stock if the price drops to $225.  Once the shares trade the designated stop loss level it will trigger the sale of shares. In this case $300 locking in a $1,500 profit. 

This method works most of the time. But there are some situations in which it doesn’t do its intended job.

If there is bad news and the stock gaps lower one morning, the first trade of the day will trigger the stop and that could end up being a terrible price.  

For example, Amazon (AMZN) stock today initially opened down over $120 at $1695, following a disappointing earnings report.  That’s the price you would have sold your shares for if you had a stop loss at any higher price. 

By midday, the stock has cut the losses by more than half and the stock was back to $1760, or more than $60 higher than where the stop loss kicked you out of the position.  Ouch. 

One cure for avoiding gaps is to use stop-loss “limit,” meaning only order which will only trigger the sale of stock at a specified price.  This could give you time to assess the reason for the gap and then make an informed decision. 

Overall, stop-losses work well when trading stocks. It’s natural to want to apply the same stop-loss order technique to option trades. But, options are not stocks and must be traded differently.

There are many factors that go into the pricing of an option and you may be stopped out of the trade because of something totally irrelevant (and temporary).

If you own an option and the implied volatility implodes, your stop-loss price could easily be triggered, even if the stock is performing to your satisfaction. 

Like shorting stocks, if you sold a put or call option, you can set a buy-stop order. If the stock trades at that price or higher, the options are bought at the market price, limiting losses.

Among the other challenges in using stops on options is you must decide what triggers the order.  Since the options of many stocks don’t trade as much volume as the underlying shares and may also have a wider bid/ask spread, you must decide you want it triggered by the bid price, the ask price, or if the option actually trades at a specific price.   

My advice is to let the underlying share price trigger the option stop-loss.  The option’s sale will be executed as a market order, which could be bad in listings with wide bid/ask spreads.  It’s not perfect, but it will still provide a mechanism of limiting losses. And that, after all, Buffet’s “Rule No. 1.”

CBOE shares were trading at $114.50 per share on Friday afternoon, down $1.20 (-1.04%). Year-to-date, CBOE has gained 18.12%, versus a 22.36% rise in the benchmark S&P 500 index during the same period.

About the Author: Option Sensei

Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...

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