When using option Credit Spreads or Iron Condors to generate monthly income, you need to place a stop loss order to establish a MRA (maximum risk amount) for every trade.
In previous articles we covered protective stop orders for credit spreads in terms of money management (Account Money Management – Avoid Account Death), and with respect to alternatives to stop orders (Option Stop Loss Orders – There Are Often Better Choices). Here we will discuss the pros and cons of, and the mechanics involved in, triggering a credit spread stop order based on the price of the spread itself vs. based on the price of the underlying stock, index, or ETF.
Whether you use the rigid entry rules of The Monthly Income Machine, or some other method for establishing spreads with a known and high statistical probability of success, there will always be some possibility of a trade going the wrong way. As noted, a protective stop order for an option credit spread can be established with the “trigger” for the stop being either: (1) triggered by the net premium value of the spread itself, or (2) triggered by the price of the underlying stock, index, or ETF
Suppose we have an XYZ credit spread on which we collected a net premium of $0.44 up front, and we choose to limit our risk on the spread to a maximum loss of $0.66 (MRA = 1.5 times net premium received).
Simple Stop on the Spread
The first trigger method for stopping out of the trade involves simply placing a stop order on the option spread itself.
Let’s assume we entered the XYZ option spread when the underlying XYZ stock was at $102. Our spread is a bull put spread and we collected $0.74 on the short May 80 strike price Put, and we paid $0.30 for the long the May $75 strike price Put, resulting in the net credit of $0.44/share for the spread. In summary, our entry position is:
- XYZ at $102
- Sold May $80 XYZ Put @ $0.74
- Bought May $75 XYZ Put @ $0.30
- Net credit = $0.44
Being a seller, we want the collected premium $0.44 to diminish into zero. Nevertheless, when the market does not get along with us, the spread of $0.44 will go up, causing a loss. To place our protective stop order on the credit spread itself to exit the trade, we simply reverse the buy and sell on the two legs of the spread if our maximum risk amount is reached.
For instance, if we set the stop loos as the spread reaching a level that represents a $0.66 loss, it means that an adverse (down) move in XYZ stock caused the option spread to widen to $1.10 ($1.10 price paid to exit, less $0.44 premium collected = $0.66 loss). Our stop order is:
- Buy May $80 XYZ Put to close
- Sell May $75 XYZ Put to close
- If spread reaches $1.10 or more
This is a perfectly good method for assuring that an adverse move against our trade does not result in an unacceptably large loss. (In the final section of this article you will see the reason we prefer to re-enter the stop order each day as a “day order” after the market has opened and traded for a while, rather than as a good-until-cancelled order.)
Contingent Stop on the Spread
The second trigger method for stopping out of the trade involves placing a contingent stop order on the option spread, with the triggering contingency being that the underlying reaches a particular price.
In our XYZ trade example, this approach requires that we answer this question: where would the underlying XYZ stock be if the spread has moved against us to the extent that our loss on the option credit spread would be $0.66 if we exited from the trade at that point?
An estimate of the answer is supplied by the use of delta, a derivative of the Black-Scholes Option Pricing Equation that won its creators the 1997 Nobel Prize in Economics. Happily, the delta values for our XYZ spread strike prices are provided in the options chain tables supplied by any options-friendly brokerage you are using.
Let’s look at the deltas in effect at the time we entered our trade position. When XYZ at $102,
- Sold May $80 XYZ Put @ $0.74: delta = 0.07
- Bought May $75 XYZ Put @ $0.30: delta = 0.03
- Net Credit = $0.44
Now, delta is commonly used as a short-cut method for approximating the mathematical probability of a particular option being in-the-money at expiration, an outcome we definitely don’t want to happen with a credit spread. The May 80 strike price delta value of .07 when we established our example spread, for example, means there is a rather low 7% probability that the 80 XYZ put will finish in-the-money when the option expires, i.e. there is a 7% probability that the underlying XYZ stock will have fallen to 80 or below on options expiration day.
However, the actual definition for delta is that it estimates how much an option will move for every $1.00 the underlying moves. The value for delta will change based on such factors as change of the underlying’s price, implied volatility of the option, and time remaining until option expiration.
Since we are dealing with a spread, and want to estimate at what price the underlying will be if the spread reaches the point where we want to abandon the trade, we need to consider the deltas for both our short XYZ 80 put and our long XYZ $75 put.
If XYZ is going down (against us), the short strike price 80 put leg of the spread will be going against us $0.07 every dollar XYZ itself declines, while the long strike price 75 leg will be going with us $0.03 for each dollar of XYZ decline. So, the net effect is the spread will be going against us $0.04 ($0.07 – $0.03) with each dollar decline in XYZ stock. (This, of course, is an approximation – not a guarantee!)
Remembering your high school algebra (you do, right?), we are left with a simple ratio-and-proportion problem to tell us roughly where the underlying would be if the spread reached our MRA amount, i.e. to a $0.66 loss that occurs at a net premium of $1.10 (1.10 – 0.44 = 0.66).
In other words, how much does the underlying XYZ stock have to go down to bring the option spread to $1.10?
(Recall that our spread began at $0.44, the net premium we collected, to which we add the $0.66 adverse move loss we are willing to risk = $1.10)
Since the delta for our short 80 put is given as .07, and the delta on our long 75 put is given as .03, our net delta for the spread is .04… the option is estimated to move $0.04 for every $1.00 the stock moves.
So, “X” will be how much the stock will have to fall to correspond to the option spread net premium moving $0.66 to $1.10.
.04 = 0.66
.04 X = 0.66
X = 16.5
Result: when we entered our XYZ spread, we now know ahead of time the trigger price to use for our contingent stop on the XYZ underlying:
- $102.00 (current price of XYZ) – $16.50 = $85.50 (stop loss trigger price for contingent stop loss order)
Therefore, our contingent stop order would look like this:
- Buy May $80 XYZ Put to close
- Sell May $75 XYZ Put to close
- Contingent upon XYZ stock falling to $85.50 or less
Good News Shortcut:
Now that we’ve plowed through the calculations that form a rational for our contingent order, there is a very simple shortcut for estimating how much the stock must move before we want it to trigger the contingent trade:
Just divide the MRA by the net delta. The result of this simple division is the amount of movement of the underlying stock we are willing to accept.
Then subtract this amount from the current price of the underlying stock, and you have your contingent stop point for triggering your protective stop order for puts. For calls you just have to add instead of subtract.
From our previous bull put spread example:
Puts (102 – ($0.66 / $0.04)) = 85.50
Or as a spreadsheet style formula for put spreads:
Stock Price – (MRA / Net Delta) = Put Contingent trigger price.
For bear call spreads, we’d use:
Stock Price + (MRA / Net Delta) = Call Contingent trigger price.
Either of Stop Triggered by the Price of the Spread Itself and Stop Triggered by Price of the Underlying (Contingent Stop) can be used.
The “plain vanilla” one is more exact; the contingent stop on the underlying is an estimate based on a calculated underlying trigger price, but may be more convenient (can more safely be entered good-until-cancelled), particularly when the stop is far from the current market.
The contingent stop calculation described above is very sensitive to a low net delta value, especially if coupled with a relatively high MRA. When these conditions exist, you may well compute a “nonsense” result that would place the contingent stop on your underlying beyond the strike price of your credit spread. In such a case, you must simply abandon the contingent stop approach based on the delta-derived formula. You can still use a contingent stop on the underlying, but you would need to base it on some other factor such as a chart support or resistance point.
Note also that the “answer” supplied by the contingent stop calculation is an estimate. The price of the underlying corresponding to a particular price of the associated options is based on the current delta value and is also based upon the amount of time remaining until expiration, current volatility, etc. These market factors can undergo change along the way, so as noted above, the calculated contingent stop point arrived at can and will change.
For many investors the somewhat less convenient conventional credit spread stop order, placed every morning after the market has opened and traded for a while, provides the most certainty. This is because it can be triggered at exactly the spread price you wish.
And, yes, if you employ the conventional stop order based on the spread price, I suggest that you enter it anew every day.
Why not enter this kind of order good-until-cancelled?
You will recall that stop orders become “market orders” when triggered. Investors sometimes overlook the fact that a stop is also triggered by a trade at the specified trigger price or by a “bid” (on a sell stop) or an “ask” (on a buy stop).
Since options generally trade with much lower volume than the underlying stock, index, or ETF, the unexpected and unwanted fill on a conventional option spread stop order is more likely to happen when the price of the option is the trigger than when the price of the underlying is the trigger.
This is because a trader can be burned by having his plain vanilla option spread stop order on the spread itself filled on the open, even though the underlying stock has not moved against him at all. This happens when outlandish option bids and offers were placed by other investors before the market opening in the hopes of catching an unwary investor’s “market order.”
The benefit of the contingent stop is that it is somewhat safer to use on a good-until-cancelled basis. As noted previously, a good-until-cancelled order is also generally more convenient than entering a stop every day, especially if you have a tendency to oversleep or cannot be at a computer when the market has just opened.
The trade-off is that the contingent stop is less precise and sometimes cannot be used at all if the formula produces a nonsense result as it can when the net delta is very small (e.g. .02) and/or the MRA is quite large (e.g. $1.50).
The contingent order on the underlying can also be very useful – and is much more precise – when you are focusing your stop trigger not on the net value of the spread, but on exiting from the spread if the underlying breaks through a significant chart support or resistance point.
For example, in the XYZ example we’ve been using, we might have decided that the current up trend line of XYZ would be broken through on the downside if XYZ fell to 91.60. We might not be comfortable staying with our bull put spread if XYZ moved into a downtrend situation, and thus might choose to use a contingent stop with the trigger being XYZ falling below the trend line to, for example, a price of 90.00. This may well make more sense than risking allowing the spread to reach the 85.50 calculated, MRA-based stop on the underlying.
An important caveat re: contingent stop orders: since the trigger price for a contingent stop is calculated using delta, you must keep an eye on the net delta of your spread. Deltas can change, sometimes dramatically, in response to sudden big moves in the underlying, news events that increase trader excitement in one direction or the other, and the mere passage of time.
When the net delta changes, you need to re-calculate your trigger price on the underlying using the current underlying price and the current net delta.
Use the shortcut method described earlier to establish the new trigger price.
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