Using Stop Orders to Sell Options
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Stop Order Definition:
A Stop Order is an order type that executes (buys or sells) once a certain price point has been reached. But wait, it's not what you think. A Buy Stop Order is placed above the current market price and executes once the stock or option price increases to that point. A Sell Stop Order is an order placed at a price point below the current market price and would sell your stock or option once the price falls down to that price point. A Sell Stop Order is also know as a Stop Loss Order!
To be a little more precise, a Stop Order triggers once the bid price matches the Stop price and at that point it becomes a market order. So if GOOG is at $700 and you place a Sell Stop order at $675, then once the bid price hits $675 or below it becomes a market order so you could end up selling your GOOG shares somewhere near $675.
A variation of the Stop Order is a Stop Limit order which works exactly the same way except once the bid price hits your price the order becomes a limit order at that price and not a market order.
Difference between Sell Stop Order and a Sell Limit Order
A Sell Stop Order is an order to sell a stock or option at a price below the current market price. This contrasts with a Sell Limit Order which is an order to sell a stock or option at a price above the current market price.
These order types are very different and it is critical that you know the difference between the two. Suppose I owned AAPL stock and purchased it at $500 a share. If I want to make sure that I don't lose more than 5% or $25 per share, then I would place a Sell Stop Order at $475 and this order would execute if the price ever dropped to $475 or below. This is more of a defensive or risk-averse order that it placed to make sure you don't lose too much money on any one stock. On the other hand, if I expected AAPL to go up to $550 and that I was content to make $50 or 10% then I would place a Sell Limit Order at $550 and then this order would sell my shares once the stock went up to $550 or more.
Difference between Buy Stop Order and a Buy Limit Order
Let's review that definition before we continue the topic of using stop orders to buy or sell options. A Buy Stop Order is an order to buy a stock or option at a price above the current market price. This contrasts with a Buy Limit Order which is an order to buy a stock or option at a price below the current market price.
Buy Stop orders are not as common as Sell Stop Orders but you need to know what they are because they do come in handy for trading both stocks and options. If AAPL is at $500 and has been trading in a tight range of $495 to $505 but I expected it to pop out of that range to the upside, I would place a Buy Stop order at $506 which would execute once the stock hit $506 or higher. This compares to a Buy Limit order which might be your obvious choice to place a Buy Limit at $495 and catch it on the cheap side of its trading range. The problem with using the Buy Limit Order is the stock may never pop out of the range and I would have my money tied up in a stock that continues to trade in a tight range. The other problem with using the Buy Limit Order is that the stock might NOT pop out of the trading range to the upside--it might drop out of its range in which case you would buy a stock at $495 that is on its way down to $450. And we certainly don't want to buy a stock as it begins its downward fall!
When trading options, prices can move very quickly. When buying calls or puts, I place a Sell Stop Order on an option within a few minutes after buying it. So if I bought a call or put option at $3.00 I would watch it for 5 minutes or so to see if there is price movement. If it is staying steady or dropping slightly I would place a Sell Stop Order at $2.50 to protect my investment. If I was watching it for a few minutes and it moved up quickly to $3.50 (which is what I hope) then I would place a Stop Loss Order at $3.10 to lock in my profit. This is the scenario that you aim for!
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