How does Stop Loss work?
Stop losses triggers will close a position and exit the trade if the SL price is reached. It works differently for long or Short positions.
Example with Short Options: If you sold a Put at @ $1.0 (Short Put) and set the Stop Loss at 80%, then the algorithm will close the trade If the market price of the put reaches $1.80, as the loss would be $0.80 or 80%.
Example with Stock + Options: Assume that you sold a stock + options (100 shares + 1 contract) and you set up the Stop Loss at 10%. Total premium received for position is $2,788 ($2,694.00 from stock $84 from option). The Stop Loss triggers if the whole position market value reaches $3,066, as losses would be $278 or 10%.
- Premium received: $2,788 ($2,694.00 from stock $84 from option)
- Stop Loss setting: 10%
- Exit price: $3,066, loss $278.
For long positions, the Stop Loss go from 0 to 100% as the maximum possible loss is the total amount paid for the trade.
Both Stop Loss and Percentage of Maximum Proffit "Early Exit" Triggers are calculated in the same manner and require step by step evaluation.
First, let us look at the Max Profit Trigger.
The early exit condition of exit at %of Max Profit is calculated at the Max profit level and not at the end of the day price. Let me give you an example:
You are short on a contract.
Received $1.90 premium
End of day Price Day N: $1.20
End of day Price Day N+1: $0.90
Position 50% max profit at $0.95
We assume that you have a close order @$0.95 and that at some point during that day that price was met and the order executed (the only way to go from 1.20 to 0.90 is to pass through 0.95), so the position should be closed at 0.95 and not at 0.90.
As in the % of Max Profit, the Stop Loss is calculated at the stop loss price and not at the end of the day price. Let me give you an example:
Using the same example as above:
- Sold a Put at @ $1.0
- Stop Loss at 80%,
- Close position if the Put market price reaches $1.80
- Day 1, end of day EOD price: $1.60
- Day 2, EOD price: $1.95
In order for the price to get to $1.95, it would have to cross the $1.80 level. So it is sound to assume that your stop loss order would be executed at the $1.80 level. So the algorithm will exit the position at the stop loss price ($1.80). Unfortunately, this is not enough. We need to check if this price was realistic.
The second question we have to ask ourselves after calculating the execution price for closing the trade is whether that price could historically be executed.
To illustrate that situation we are going to look at another example. This time we use a LONG Options Contract. You have a STOP LOSS at $118. Current price is $120. Next day the price goes down to $112. If you had an SL order at $118, in order to go from $120 to $112, at some point the price had to cross the $118 ticker. So the order was executed. Except in one case.
What is the instance, in which, we can't execute the order at $118? To answer the question we need to look at the opening price for the contract. In this example, in Table 2, we see that the opening price was $115. So the order at $118 is not executable. The price crossed that level overnight. So the closest price is the opening price. The Stop Loss order would be executed at the opening at a $115 price.
In table 3, we see that if the open price was $119, then we can confidently assume that the SL Order was executed at the $118 level.
The Stop Loss is triggered if the EOD (End of Day) price - see here for more on EOD prices - is:
You can also use the OPEN and the High LOW prices for triggering the stop loss.
You now can select at what price do you want the stop loss to be executed.
EOD: Executes the stop loss at the end of day EOD prices. This is our default choice, and it is the most pessimistic assumption. It is also the easiest to replicate in real life trading. You look at the market price at 3:45 P.M. and, if the stop-price is tested, then the position is closed using the EOD market price.
Calculated: The trade is closed using the stop-price, regardless of the EOD price. Using the same example as before, the position will be closed at $118.