Suppose you’re a stock trader who’s heard about using options to protect a position instead of a stop loss. The appeal is simple. You can avoid getting whipped out of trades that hit your stop loss only to move back in the right direction. We call that whipsaw. It’s frustrating and happens even to the best-placed stops.

The idea is intriguing . Today we’re exploring it and suggesting an alternative strategy that accomplishes the same thing, but at a much lower cost.

Alaska Air Example

Let’s look at an example using a pick from last weekend’s Options Report – Alaska Air (ALK). The airliner had a three-bar bull retracement pattern, with the pivot low at $32.78. As a swing trade, I would have looked to buy it over Friday’s high ($35.12) with a stop under $32.50.

Instead of buying with a stop loss, though, I could have purchased a protective put. It limits my risk but doesn’t have the potential of whipsaw. Let’s say I bought the stock for $35.12 and simultaneously purchased a July $35 put option for about $4. Here’s what the risk graph looks like:

The profit potential is unlimited because you own stock, but the loss is capped at $412 if the shares plunge because of the protective put. If you’re comfortable with that amount of risk, then you don’t need to worry about a stop loss.

And if $412 is too much, then you could even buy an ITM put against your stock to make it even less. For example, you could have purchased the July $40 put instead of the $35 strike.

Here are the two key takeaways:

1. Use a put instead of a stop loss.

2. If you want to reduce the max loss then buy ITM instead of OTM.

You can use the same technique for shorting stock. Instead of using a stop loss you can purchase a call option against the stock.

Now, here’s where synthetics or equivalent positions comes in.

Synthetics

There’s a mathematical relationship between puts, calls, and stock. It’s known as put-call parity. Essentially, you can take two of the three instruments and synthetically create the third. Here are a few examples:

Long stock = Long Call + Short Put

Short stock = Long put + Short call

Long Call = Long stock + Long put

Long Put = Short stock + Long call

Do you notice anything familiar with the long call and long put? The equivalent positions are exactly what we explained on ALK. By purchasing ALK stock and buying a put option, you are creating a synthetic long call. More specifically, buying 100 shares of ALK and buying one July $35 put is the equivalent of purchasing one July $35 call option.

If the protective put has $412 risk and unlimited reward, the long call will too. Their risk graphs are identical. So here’s my point.

If you like the idea of using protective puts on stock to avoid getting whipped out with stop losses, then why don’t you just buy a call option instead? It offers the same payout potential as the protective put, but it’s way cheaper. Buying the July $35 call for ALK would have been around $400. Buying 100 shares, even on margin, was like $1,750.

The same goes for shorting a stock and buying protective calls. That is a synthetic long put option. So why not just buy puts? That’s what I would do.

Legal Disclaimer

Tackle Trading LLC (“Tackle Trading”) is providing this website and any related materials, including newsletters, blog posts, videos, social media postings and any other communications (collectively, the “Materials”) on an “as-is” basis. This means that although Tackle Trading strives to make the information accurate, thorough and current, neither Tackle Trading nor the author(s) of the Materials or the moderators guarantee or warrant the Materials or accept liability for any damage, loss or expense arising from the use of the Materials, whether based in tort, contract, or otherwise. Tackle Trading is providing the Materials for educational purposes only. We are not providing legal, accounting, or financial advisory services, and this is not a solicitation or recommendation to buy or sell any stocks, options, or other financial instruments or investments. Examples that address specific assets, stocks, options or other financial instrument transactions are for illustrative purposes only and are not intended to represent specific trades or transactions that we have conducted. In fact, for the purpose of illustration, we may use examples that are different from or contrary to transactions we have conducted or positions we hold. Furthermore, this website and any information or training herein are not intended as a solicitation for any future relationship, business or otherwise, between the users and the moderators. No express or implied warranties are being made with respect to these services and products. By using the Materials, each user agrees to indemnify and hold Tackle Trading harmless from all losses, expenses and costs, including reasonable attorneys’ fees, arising out of or resulting from user’s use of the Materials. In no event shall Tackle Trading or the author(s) or moderators be liable for any direct, special, consequential or incidental damages arising out of or related to the Materials. If this limitation on damages is not enforceable in some states, the total amount of Tackle Trading’s liability to the user or others shall not exceed the amount paid by the user for such Materials.

All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.