You should have two important skills if you want to become a successful trader. Fir♒st is the ability to pick the right markets. The second is the ability to think on your feet when the market turns against you and knowing when to exit a position.

Many trading techniques and strategies teach these skills but conventional trading wisdom insists that the proper way to protect yourself from losses is to use a stop order. Stops are useful but some inherent problems can be overcome by using options as an alternative. Options have properties that are favorable f🦹or those who are looking to💃 protect a position.

Disadvantages of Stop Losses

A 澳洲幸运5官方开奖结果体彩网:stop order becomes a market order when the price of a security surpasses a predefined entry/exit point. You pick a trade and your stop is triggered and you're kicked out for a loss if the market moves against you. This is unfortunately like the emergency brake in your car. It does the job but there's little finesse or control in🦋 how and when the car stops. Almost anything can happen when a stop is triggered and it becomes a market order.

Several market scenarios expose the inherent flaws of stops and their inability to protect you from unexpected losses. Stops force traders to jump ship whether it's fast-moving markets, consolidating markets, or fundamental shifts in 澳洲幸运5官方开奖结果体彩网:supply and demand. It's a one-size-fits-all so🦹lution that's better handled by using options to ease out of the position, shift market time frames, or reverse the position.

Options As an Alternative

There's no guarantee that you'll receive your stop price when you use a stop-loss order in a fast-moving market. The stop is a reactionary tool designed to get you out of the market immediately when you're losing money so there's a good chance the fill price will be worse than the price you set in the order. This is known as slippage.

You're hoping to limit a loss to $1,000 (a $1 decline in contract price equals a $100 loss) if you go long on gold futures ꧂;at $1,280 and set your stop at $1,270. It turns into a market order, however, and you may not exit until $1265, generating a $1500 loss or 50% more than you had anticipated, if your stop is triggered in a fast-moving🐠 market.

You can't lose more than the 澳洲幸运5官方开奖结果体彩网:strike price, 🎶however, if you use an option with a strike price of $1270 instead of a stop in t🌼he same market.

Advantages of Using Options

You have to pay the option's premium but two things can work in your favor here. 澳洲幸运5官方开奖结果体彩网:Out-of-the-money options typically cost less than 澳洲幸运5官方开奖结果体彩网:in-the-money options. Options that gain value when there's an opposite move to the current market's trend tend to have less volatility as well. This tends to make them less expensive. Using an option in this way is known as a 澳洲幸运5官方开奖结果体彩网:hard stop and it's the easiest way to directly control slippage while m▨anaging loss.

The use of a protective put is an example. A put option gives the holder the right to sell the underlying asset at a predetermined strike price so the protective put sets a known floor price below which the investor won't continue to lose any added money. This is the case even as the underlying asset's price continues to fall.

Consolidating markets are a second market condition where stops can work poorly. It's rare for any market to move straight up or down. Unfortunately, you never know if the counter-trend is simply a consolidation or a trend change. Stops can't differentiate between alternatives so you're forced out and have no stake if the market was simply consolidating and it resumes movement in the direction of your original position. This is known as the whipsaw effect.

Stops leave little room for consolidation and retracement behavior. You could&n🐻bsp;be right about the market but stuck on the sidelines because the stop was placed at the wrong price or at the wrong time. You can hold onto a losing position for a longer period while determining if the market is consolidating or changing trend, however, if you place an option where you would have placed your stop.

You can diminish the impact in two ways by having an option in place of a stop during fundamental shifts in the market. You'll insulate yourself from moves that aggressively erode your position because the option is gaining at the same pace. And you can leg out of the position without 澳洲幸运5官方开奖结果体彩网:chasing the market if the shift doesn't generate aꦏ big move but does signal a trend change.

The Bottom Line

Options present a clear alternative to using stops to manage losses. Look at trading the same way 澳洲幸运5官方开奖结果体彩网:money managers do. They recognize the interdependence of underlying assets and 澳洲幸运5官方开奖结果体彩网:options contracts and a built-in 澳洲幸运5官方开奖结果体彩网:risk management relationship that can diminish losses𓆉. They use finesse and control through thi🔯s approach to protect themselves from fast-moving markets, consolidating markets, and fundamental shifts in supply and demand.

Disclosure: Investopedia does not provide investment advice; investors should consider their risk tolerance and investment objectives before making investment decisions.