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In volatile markets, stops will often get hit and then the market will reverse. Dan Collins from Futures magazine discusses using options to limit risk instead of stops.

My guest today is Dan Collins of Futures magazine, and we’re talking about using options as a hedging tool and as a risk management tool, rather than stops, so Dan, talk about this strategy.

Okay well, it’s not a strategy specifically, but it’s a tool—it’s another one of the tools that options provides, because if you see—I know when we’re going to hear this, but this is a day after the Fed did their Quantitative Easing 3 and a lot of markets whipsawed, which you see in a lot of actions, and that will have the effect of taking you out of a position that may have been profitable.  One of the benefits of options is you can use it as a risk management tool, where you have that protection where you’re not necessarily stopping yourself out, so you still maintain your opportunity and you can limit your loss to a certain area.

All right, give us an example of maybe an XYZ stock at 20 and using options as a stop loss, just garden-variety strategy here.

Well, I mean, mainly what that would be doing is buying puts, which puts a floor under your stop, and if it hits there, it may be out in the future, so you’re covered, but if it comes back and you’re not stopped out.  Now, in futures, you have a stop, and if there’s a big announcement, not only are you stopped out, but sometimes you’re stopped out not at a worse price, because a stop just turns into a market order, so it just gives you a little bit of extra flexibility.

All right, let’s talk about strike prices and expirations.  Do I want the closest expiration and how close in the money and out of the money should I be?

Well, it depends on what you’re doing.  If you’re using it as a risk management tool, you’re setting your limit, your price by buying a put or a call above or below the market, but what we are seeing is kind of a growing sophistication in the use of options and to give you an example, in our October issue we examine the hot new CTA’s.  Every one of them is an option trader and they’re not your flat out option writers like we’ve seen in the past, which is a good program if done right, but it can be a little bit scary.  The joke is you’re always picking up nickels in front of a steamroller and what we’re seeing is today’s option traders are not just doing the flat out option writing, they’re doing more of that--I kind of coin it as a volatility value trade where they’re going to sell the options when the premium is high, but they can offset as a hedge, but not only as a hedge by buying options if the premiums are depressed.

What do you think has led to this more interesting option?  Is it just the evolution of the retail trader that they’re getting more sophisticated?

I think so.  I mean, we’ve been doing your shows for a long time and we’re kind of seeing the level of sophistication rise because options, some people say they’re safer, but they could be more risky if you don’t understand it and they’re definitely more complex.  A lot of people like to say it’s playing chess instead of checkers, and the good thing about options is you can define your risk on either side of the market.  The bad thing is that sometimes a little bit of knowledge can hurt you because working on the floor I’d always recall people would always call me and say, the market went here, my option didn’t move the way it was supposed to.  Well, they were being economical and purchasing further out of the money options and the delta was not there, so it didn’t move with the market and they got upset, but it’s a great tool.