Most people know what stop orders are.  

But, many don’t know that you can use stop orders with options and option spreads.  There are some very important factors to take into account here though especially with option spreads. 

How It Works

The issue here is that most option platforms calculate a “theoretical value” for an option spread.  Using the bid/ask spreads for each leg of the spread, you can calculate a “theoretical value.”  

Let’s take an example in Facebook (FB).  Let’s look at the 10/3 (weekly) 72.5/75 put spread.  On October 3, the 72.5 puts had a market set at .50/.52 and the 75 put market was 1.10/1.11.  Very tight, very liquid markets.  So, the spread market was .58/.61.  This is calculated by selling the bid in the 75’s and buying the offer in the 72.5’s (1.10-.52) and buying the offer in the 75’s and selling the bid in the 72.5’s (1.11-.50).  I could have bought the spread at .61 or sell it at .58 and the theoretical value of the spread was simply the mid-price which would be (.58+.61)/2 or .595. 

Stop Orders

If I set my sell stop price at .50, as soon at the theoretical value equals .50, a market sell order is generated.  But what if, for whatever reason, the market makers dramatically lowered their bids?  It doesn’t happen often, but it can happen.  So, let’s say the markets are now .25/.52 and .55/1.11.  The bids across the board just simply decreased dramatically. 

Key Takeaway

Now the spread market is .03/.86 with a theoretical value now .445.  So, in an instant, and really for no reason (other than the market makers took 50% of the premium out of their bids), my stop would have been triggered.  It is something that you must consider if you are going to utilize stops in your option trading methodology.

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