Stop-loss question

[hsuwang]

Hello David,

Can you help me with this following question:

An options trader sells a call with a strike price of $40. Which of the following describes a stop-loss trading strategy?
a. The trader holds the underlying stock.
b. The trader puts in a limit order for the stock if it rises above $40.
c. The trader puts in a buy order for the stock if it falls below $40.
d. The trader holds the underlying stock if the stock price rises above $40.

I’m guessing B would be correct, but I’m not sure about it.. If instead B says “stop order” instead of “limit order”, would it still be correct? and also can D be correct as well since holding the underlying stock can in a way help prevent further loss.

Thanks.

 

[David Harper CFA FRM]

Hi Jack,

I feel that's a tough question because "stop loss" is a type of order ... so we'd have to remember this is a specific strategy illustrated by Hull (that he uses as a "straw man" before illustrating the delta hedge).

From Hull 17.3: "Stop-loss strategy: To illustrate the basic idea, consider an institution that has written a call option with strike price K to buy one unit of a stock. The hedging procedure involves buying one unit of the stock as soon as its price rises above K and selling it as soon as its price falls below K. The objective is to hold a naked position whenever the stock price is less than K and a covered position whenever the stock price is greater than K.. The procedure is designed to ensure that at time T the institution owns the stock if the option closes in the money and does not own it if the option closes out of the money."

Therefore, (D) looks to be correct.

About (b), that looks to be incorrect b/c I *think* we can have a limit order @ $40 (i.e., sell at 40) but i don't think you can say "limit if price rises above 40"...a limit may not be executed...rather, you could have a stop (sell) @ 40 or a stop-limit (stop @ 40, limit @ 41) but a "limit above X" appears to be contrary to the conditional nature of a limit order

And (c) looks like it's only one-half of the strategy; i.e, only the buying not the selling

David

 

[hsuwang]

Hello David,

so what if B says "b. The trader puts in a stop-limit order for the stock if it rises above $40?"

will this make sense? How I interpret this is once the stock price rises above 40, (stop@40, limit@40), then stop order is triggered into a limit order to buy at 40 or higher, but not lower. so would this considered to be an eligible answer?

also, I'm not really sure how limit order works on the "buy side" (buy when prices goes up to the limit), I think I'm pretty clear about how limit order works on the "sell side" ---
"Once the stop price is reached, the stop-limit order becomes a limit order to sell at the limit price or better. " but for the buy side, does it even make sense to "buy" when stock prices goes up? Usually it's more understandable to buy when stock prices hit a low stop price right?

Thanks.

 

[David Harper CFA FRM]

Hi Jack,

Re: what if B says "stop-limit order for the stock if it rises above $40"
Yes, it could be a stop-limit @ $40 (actually, that's a stock-and-limit when stop = limit)

...so for stop-and-limit @ $40, I agree with this: "once the stock price rises above 40, (stop@40, limit@40), then stop order is triggered into a limit order to buy at 40"
... but the limit cannot be to buy "for 40 and above" .... the limit (to buy) is $X and can only executee (to buy) at X or less (i.e., at price or more favorable) ... so a limit to *sell* at 40 could be 40 or less...

Re: limit on the buy ....as above, limit to buy @40 is an order to execute at $40 or more favorable (less on the buy side) ... I'm not sure how it's fundamentally diffferent for buy/sell as the limit order just says "I want this price but only if you can get it; if not, don't do it"

David

 

[hsuwang]

ok thanks David!

 

[syaiful]

Hi David & Jack, :lol:

is this "sell a call" refer to Put-Call ?, so if the K > $40 we can get "Loss".

so we need to "Hold" the underlying to "Stop Loss" ?


Regards,

*Syaiful S

 

[David Harper CFA FRM]

Hi Syaiful,

I don't you may be party right about the "hold" but it's easy to over-analyze Hull's "stop-loss" hedge strategy.
He means it as a naive "straw man" that doesn't work very well:
if you write a call, then this strategy just wants you to "cover" the call if the call is ITM for your counterparty: if S > K, then you payout on the written option but you have the gain on your share
if S < K, then this strategy wants you to be naked: no option loss and no underlying share needed.
this "stop loss" is probably simpler than you are thinking...it's prelude to the harder dynamic delta hedge

David