Setting option stop loss prices

I decided to pop this into a separate post, I get carried away with posts and they tend to meander from topic to topic as my thought processes hit upon various aspects that appear as I write. I don't mind this so much as this is mostly for me to clear my mind and get some of this stuff down rather than for public consumption...any who can follow along, great.

Previously I mentioned considering the Extrinsic Value as a slush amount. Basically, with regards to setting the initial worst case stop loss price, the EV should be discounted wholly and use the Intrinsic Value only. This would be done by taking the difference between the stock price when the option was purchased and the stock price that would be used as a stop in a standard trade and apply that to the IV of the option.

So an option at $10 with and IV of $8.50 and an EV of $1.50 leaves the $1.50 off the table. If the stock was trading at $30 and the stop would be at $27, apply that to the IV which puts the worst case stop at $5.50. A total potential loss of $4.50 per contract. Sounds high as this represents a 45% loss.

Keep in mind that this is only to allow the option room to move. If the stock plummets (assuming a call option is purchased) then this is not necessarily a bad deal. I would exit the option trade at the point when the stock reaches it's stop setting of $27 and I honestly expect that the option will still have some EV left so the loss is not likely as great as it appears.

More reasoning.

It would be a shame if the stock volatility dropped off, like the IPI example, causing the option to get taken out before the stock moved. In the IPI case the stock price went up 20 cps while the option dropped 50 cps. I will not close my option position when the stock is not even dropping.

In my case I hold both the option AND the stock so a drop in price AND volatility will hit me twice as hard...but this is an experiment.

This leads to another question.

Is it fair to consider the standard loss allowances used for stock trading to apply to options trading?

That depends.

Assume a 2% capital loss allowance per trade. On a $20K account that is $400 per trade risked.

My IPI trade was for $6.40, IV of $4.40, EV of $2.00. My stop loss allowance on IPI stock would be $2.50...that makes a total of $4.50 risked (EV + Stoploss). Worst case.

So I would set my initial stop at $1.90. (Option - EV - Stoploss) ... OUCH!

A more recent trade example.... AEO.

Option purchased for $4.40, stock price of $14.10.
IV = $4.10 EV = $0.30 (6.7%)
Stop on the stock = $13.00 ($1.10 stoploss)

4.40 - 0.30 - 1.10 = $3.00

Total risk = $300 or 1.5% for the $20K account.

So, yes it is reasonable to apply the standard loss allowances. The problem comes into play with larger stock prices. A $14.00 stock may have a comfortable loss setting at $13 or so but a $50 will be a larger difference...so this is mitigated in trading by using smaller positions, 50 or 25 shares. In options the minimum contract size represents 100 shares.

This gets me into buying the At The Money (ATM) options and this is also where a lot of people lose a lot of cash.

A cheap option that is Out of The Money (OTM) might cost 30 cents. One contract cost $30...WOW, I could buy 100 contracts for the same as 100 shares of the same stock trading at $30. Problem is that the ENTIRE option cost is risked as opposed to the stop loss on the stock of perhaps $300.

Being right is great in that kind of a case, being wrong sucks.

Go by the worst case loss rather than even the potential gain for position sizing and I would expect that using the same share size as stock size is best of the start. I have a couple OTM options that I have bought 4 contracts but I know that I risk every penny...I likely would still get out with some cash left if it goes sour but a few of these sorts of trades are not a bad idea if the risk is known, and acceptable.

I think I rambled enough for today.

Jeff.