Online Stock Trading: Put Options vs Stop Loss Orders

Before I get into the specifics of why I hate stop loss orders, I should first explain what both of these terms mean.  A put option allows you to sell the stock that you own at a set price for a specified period of time.  A stop loss order is an order that you place with your online stock broker to sell your stock if it drops to a certain price.  If you own stocks, you need to have some mechanism in place to prevent large losses like the nearly 40% market drop that we saw in 2008 and 2009.  In the following article, I will use some examples of how the two different methods vary and why I prefer put options.

Let’s say that you owned stock in Eli Lilly (LLY) in October of 2008 thinking that drug stocks were a fairly defensive investment posture given the economic and financial turmoil.  You had purchased it in September at about $45 and felt that a 10% stop loss would be reasonable.  You entered the stop loss limit order with your stock broker at $41 per share.

Well on Friday, October 4 Eli Lilly traded down to $41.24 getting close to your stop loss.  You thought, “OK, no big deal.  If it gets stopped out, I am down 10%, and I can just wait for the market to settle down.”  On the following Monday, LLY stock opened at 40.64 and never saw $41 that day.  So, your stock didn’t sell.  You get home from work to find that you still hold LLY stock now worth $38.42 per share.

By that Friday, October 11, it is down below $30 per share.  You just can’t take it anymore.  Your nerves are shot wondering how low it can go.  You are down 25% in just one week.  You decide to sell at $30 thinking how lucky you are to get out while you can.  Forget the fact that it traded up over $40 again for a short time in December.  It is too late.  That portion of your capital is gone forever.

Now you know why I hate stop loss orders and will only use put options for the rest of my life.  I work too hard and sacrifice to save a portion of my earnings each month to lose 25% or more of it in just a week’s time.  The problem with stop loss orders is what happens when the stock “gaps down”.  You will notice that LLY stock traded above $41 on one day and the next day was below it but never reached it that day.  That creates a gap in the stock price chart.  It may take years for the stock to reach that price again if ever.  In the meantime, the whole purpose of the stop loss (which was to stop your losses) has been circumvented.

Let’s revisit the above scenario using puts instead.  Instead of a stop loss order, you purchase some protective puts with an October expiration at a strike price of $40 per share when you originally purchase the LLY stock.  The cost of the stock was $45 per share, and the puts would likely have cost about 2% of the total value of the stock at most since they would have been out-of-the-money.  That would have meant a cost of about $0.80 per share.  Your total cost would have been $45.80 per share for the stock and the puts.

You have been watching LLY stock trade down closer and closer to $40 per share but you aren’t worried. You still sleep well since you know that you can’t lose any more than $5.80 per share total even if LLY goes to $20. As LLY stock declines to $30 you decide that now may not be the best time for being in the market and sell out everything on October 11. You sell the stock for $30 per share and the puts for about $10.10 per share. Now you are out of the market with $40.10 per share back in your pocket despite the gap down and the huge weekly decline.

Let’s compare the results of the two investors. Our stop loss investor spent $45 per share and sold at $30 for a 33% loss of capital. Our put investor spent a total of $45.80 per share and lost $5.70 for a total loss of 12.4%. Who do you think will be able to make up for that loss quicker in any rebound? A 33% loss requires a 50% gain to get back to even. The 12.4% loss only needs a 14.2% gain to break even. The moral of the story is: Don’t lose your investment capital! Puts protect you and stop losses only make you think you are protected. Stop losses fail when you need them most. You could even have invested in Enron stock if you owned puts.