Options – Stop and Target prices

Tracking your Options trades can be more labor intensive than tracking other markets. Because you are trading an underlying issue, sometimes you’ll need to be slightly creative when looking to enter Stop and Target prices in the TradingLog.

Because Option prices are not linearly related to the underlying stock prices, there is no way to use the underlying stock numbers (prices) directly and produce a risk (and/or) reward amount for an option trade.

What the TJS user can do is use the “delta” value of the option to help evaluate the risk and reward scenario. For a long position, estimate the “stopped out” value of the option by multiplying the number of points (the stock-based stop is set underneath the stock purchase price) by the “delta” of the option that was chosen. Subtract this amount from the option purchase price.

 

The following example should help:

Suppose a stock price is at $20.00 and you have purchased a $17.50 Strike in the money option for $4.00. Suppose the “delta” for this option is .75 (The option chain should give the actual value.)

If you want to set a stop loss based on the stock price dropping to $18.50, you’ll need to calculate what the value of the option would be when the stock is at $18.50. There are option calculator tools that can do this but a quick way is to realize that for a stock with delta of .75, a $1.00 drop in stock price will cause a $.75 drop in the option price. So for a $1.50 drop in the stock price — $1.50 x .75 = $1.13. So when the stock is at $18.50, the option is worth approximately $4.00-1.13 = $2.87.

For the reward (Target) side of the equation, you can just estimate at what value you would be willing to sell the option, or if you want to tie it to a particular stock price, you can do it the same way by adding the option’s delta to its price for every $1.00 move in the underlying stock. This is complicated when the stock moves more than a couple of points, because delta will also increase along the way. The best way may be to look at what you paid for the option, then look at what your risk is and set a target price to sell the option at purchase price plus – 3(x) what your amount of risk is. So in this example you would estimate a stop loss value of option as $2.87, and estimate target price of option as $4.00 + (3 x $1.13) = $7.39, which gives a 3:1 reward / risk ratio.

The long and short of it is that, unlike stock prices, option prices do not correspond in a linear manner to the stock price. If you want to do the calculations exactly, you’ll need to evaluate the value of your particular option at your “Stocks” stop loss price and target price.

You may find it sufficient to use a quick head calculation of the effect of delta to set the value of the option at the stock stop loss point as described above and to set an arbitrary value for a target sell price of the option. This should permit a good enough risk and reward calculation in your spreadsheet for most purposes.

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