Can puts work as stop losses?

Question

As far as I see it, the main problem with placing stops, is that the price may rebound in the direction that you originally wanted. You might be out of the trade and have no chance of recovery.

Puts are the right to sell a security (Options for dummies. Can you explain how puts & calls work, simply?), so I could supposedly place a stop loss that will only be exercised at that exact price (avoiding being gapped over, another fallacy of stop losses) at a specific date (so if a stock rebounds, I will choose not to exercise it, and avoid another fallacy). Does this options stop loss strategy have any fallacies that I am overlooking?

Does this strategy have a name? Does it work, or are the premiums too expensive, or something else? What would be a good way to use this strategy?

Answer 1

A long put that protects a security isn't really a stop loss because you remain in the security. It's a limit the loss strategy.

The put has several drawbacks:

• It's a wasting asset

• Its delta is likely well below 1.00 so the amount of protection before expiration will be fractional.

• It adds a lot of drag to the position. For example, a one year ATM put on the SPY costs about 8%. On an expiration basis, the SPY must increase more than 8% before you make money

• The further OTM the put is, the lower its cost but the higher the deductible (loss from current price down to the strike price).

An advantage is that if the underlying tanks, at the cost of delta, if so inclined you can roll the put down, lowering your cost basis, allowing you to hang in there and you'll need a smaller recovery to break even.

There's no one size fits all answer here. An alternative is long stock collars (equivalent to a vertical spread) so that the premium sold pays for most/all of the put's cost. This greatly reduces the disadvantage of option cost when implied volatility is high. Of course, you have to be willing to cap the upside to do this.

There are more out of the box ideas that reduce risk but that's probably more than you're after.

Answer 2

A put as the right to sell a stock at a given price allows you to limit your potential losses. There is no traps laid out.
Your risk is mainly that the stock does not fall this far. For example, if you own a stock trading at 60$ and buy a put at 50$, you will lose money if the stock consolidates at 52$. Or it might take longer than the expiration date and you need to renew your options, paying a premium each time.
The other problem is that volatile stocks will face a high premium on options. Just like any type of insurance it is most expensive when you might want it the most

Answer 3

Your contemplated strategy seems similar to a married put. But by using a lower strike price (out of the money put), your strategy should be less expensive than a married put that uses a strike price at the money.