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I talk a lot about risk management, but I have never talked specifically about the best stop-loss strategy for options traders. This is an easy way to minimize potential trading losses.

What is stop-loss?

A stop-loss is an order to automatically sell a stock, bond, commodity, option, or other security when it drops to a certain price. It’s a great tool to help you sleep well at night. You know that as soon as your position falls by, say 5%, it will automatically be sold.

Benefits of a stop-loss strategy

Obviously, stop-loss helps ensure you keep trading losses to a minimum.

But a stop-loss strategy also protects you against your own hubris. So many traders place trades believing there is no possible way they can be wrong. They did their research, back tested the trade, and confirmed historical patterns. No need to play defense! This trade is a winner! That mindset can lead to a disastrous outcome of course.

Finally, none of us know what the future holds for the stock market, nor do we know how markets will respond to different news events.

In many cases, earnings surprises to the upside/downside tend to move stocks sharply in either direction, but we never know how much exactly. We could estimate the expected move by using the option straddle rule: Add the at-the-money call and put, and you’ll get the expected move of the stock as priced by the market.

But what if that “rule” does not hold and the stock moves much more to the downside than expected? Like I said, you can suffer large losses.

Why risk it?

A stop-loss strategy for options traders

Most traders and investors tend to use a stop loss of different sizes depending on their risk.

I like to follow the advice of Bill O’Neill, famed investor and creator of Investor’s Business Daily. His stop-loss strategy sits at 8%. This number may sound random, but it’s not. What does it take to regain an 8% loss? Just make 8.7% on the next trade and you’re whole! That’s not too difficult to manage.

But what if you decide to set your stop-loss at 25%? You’ll need a 50% gain on the next trade just to recover those losses. That is very difficult to achieve, especially now that you are in a slightly panicked mindset.

I highly encourage you to add a stop-loss strategy to your risk management tool box. How great will it feel to know you are safe from losing it all?

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