Stock Puts vs Stop Loss Orders

Investors are always looking for ways to cut their losses or trying to lock in profits.  Below I am going to describe three such ways to accomplish this, using stop orders and puts.

There are two types of stop loss orders, a stop order and a stop limit order.

STOP ORDER- A stop order is an order that will be transacted as a market order when the stock trades at that price.  It can be placed to close out positions if you are long or short a stock.  For example, I am long Citigroup (C) at 18 and I place a stop loss at 17.  As soon as there is a trade at 17, my stop order will be executed at the market.  The advantages of using a stop order are I can set a predefined price to exit and not have to watch the market all day.  The disadvantages are you may not get executed at the price you have set to get stopped out at.  If the market gaps down tomorrow to 16, my stop will go off at the market which is now 16, a point lower from where I wanted to get out.  The same situation may occur in “fast markets”, I will get executed at a lower price than my stop loss price of 17.  In summary, a stop order will get executed at the market once the stock touches or trades through the stop price.

STOP LIMIT ORDER- A stop limit order is transacted in the same way as a stop order except that instead of being a market order it is a limit order.  For example, I am long Citigroup at 18 and I place a stop limit order at 17.  When the stock trades at or through 17, an order will be sent to sell my shares at a limit price of 17.  The advantage of using a stop limit order is my exit is predefined if all my shares get executed.  The disadvantage is the order may not execute at all or I only get partially filled.  If the stock gaps below my stop price, the stop order will be live as a limit order to sell at 17 but has no chance of executing until it trades back up to 17.  The stock could also trade through 17 and there might not be enough shares to execute my order in full, partial, or at all.  I will have to wait until there are enough shares to trade at 17 to complete my order.  In summary, a stop limit order will get executed at the limit price you set if there are enough shares to trade at that price.

PUT- A put is a stock option that gives the buyer the option to sell his stock at a strike price by a certain date at which point they expire.  What you are buying can be thought of as insurance and the price of the options as the insurance premiums.  The strike prices can be found in newspapers or from your broker.  Without going into whether an option is overpriced or under priced which is beyond the scope of this article, I will use the same example as above.  With Citigroup trading at 18, I look and see that the December 2008, 17.50 put options are selling for 1.50 per contract or 150 dollars per 100 shares to hedge.  By buying the put I now increased my investment, so Citigroup has to close above 19.50 by  Friday in the third week in December (option expiration for the month of the December) to break even.  My risk is now capped at 2 dollars per share, 18 stock purchase price - 17.50 strike price + 1.50 premium.   In summary, a put increases the break even point of the investment and allows an investor to cap his downside risk. Even if the stock goes to zero before December, the most I can I can lose is 2 dollars per share.  I will lose 18 on the stock but gain at least 17.50 on the put minus the 1.50 per share premium.  

All three methods of limiting losses have there places and should be used by investors. 

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