Don’t Use Stops! Do This Instead…
Risk control is critical to any investment plan.
But money management discipline is more difficult to employ successfully in volatile market conditions, even though it is often said that volatility equals opportunity.
The truth is, execution of buys or sells under extreme market conditions without using stop loss orders is a dangerous gamble, not an investment. Choosing where to place that stop can be difficult. The goal is to set a stop stop far enough away to allow for market fluctuations, yet tight enough to prevent unnecessary losses.
For traders, getting stopped out can be frustrating. But not getting stopped out on a position that moves against them is often catastrophic.
Luckily, there’s an easy solution to this problem.
An often-overlooked trick that completely eliminates the use of stops while completing limiting and quantifying the risk is to use a call or put for protection instead.
Buying an option allows absolute risk control in even the most uncertain markets. The option right to sell with a put protects a long position or a put protects a short position.
The option puts in a price floor below or a ceiling above that can be exercised anytime. The risk is the dollar difference between the entry price and that option strike. Simply buying a put or call instead of an exit stop at an entry price provides risk control with staying power to ride through ups and downs.
An option is protection for a specific time period. This insurance has a cost in the premium paid. You offset this cost with the peace of mind in a market meltdown, knowing that you can’t be forced out of the position by a short-term move.
Use a put or call as protection and as a way to avoid being stopped out, while employing the risk control needed for money management discipline.
Keep it In the Money,
Trading Tip of the Day: You Can’t Outsmart the Market
The market can stay irrational longer than you can stay solvent.
It’s very difficult to find new trades right now if you are unwilling to chase the overextended tech stocks… As we talk about all the time, we have to let the market come to us. Just blindly buying these stocks going straight up can lead to disaster.
But that doesn’t mean you should try to short these high-flying tech stocks! Yes, the market’s overbought, investors are a little too excited about new IPOs, and we’re overdue for an extended shakeout. But just remember that the market can stay overbought for a long, long time — long enough to crush any short sellers in its path.
You should always be prepared for sharp pullbacks. They’ll eventually materialize. Just don’t throw your money away fighting the market’s strongest trends!
— Greg Guenthner