On a previous post titled “How to sleep well when holding an overbought stock?” I received a comment stating that having a PUT was the same as having a STOP loss. This is NOT correct. I’ll use this post to explain the differences.
A PUT is an option to sell a stock within a window of time at a price that was agreed upon. For example, let’s say I own stock XYZ that is trading at $50 and I buy a PUT that expires in 30 days with an exercise price of $45. This means that for the next 30 days I have the option to sell XYZ at $45. In effect my position is insured for a maximum loss of $5. If the price of XYZ went to $30, I would exercise the PUT and sell it for $45. Therefore, I would only lose $5.
A STOP loss order is a permanent SELL order that is placed with your broker to sell a stock at market if it hits a specific price. For example, let’s say you have a STOP loss order for XYZ at $45. If XYZ fell from $50 and traded at $45 the STOP order would automatically convert to a market order and the XYZ would be sold at market. This means that in liquid markets, depending on the execution of your broker, you should be able to sell at a price close to $45 and only lose $5. In a fast moving down market you could be selling at $43, $42 or even $40. Therefore, you could lose more than $5. The price at which you sell is not guaranteed.
Another issue with the STOP loss is that it does not protect you against a gap down opening. Again, assume you have a STOP loss set at $45. If you had XYZ trading at $50 and XYZ reported earnings after hours. Let’s say they reported a big loss when the market expected a profit for the quarter. Hence, the next morning XYZ opens at $25. Since the stock never traded at $45 the STOP would have not been executed and therefore you didn’t sell at $45. Hence, you lost $20 from where you thought you had protection from the STOP. Contrast this to owning a PUT at $45. In the PUT’s case you would be protected, you have the option to sell at $45 even after the gap opening of $25, losing only $5.
In summary, the benefits of PUTs over STOP orders are:
1) PUTs protects you 24/7
2) PUTs guarantees the price at which you are protected
The only benefit I see of the STOP is that it doesn’t cost you any premium like the PUT. However, you get what you pay for. The STOP doesn’t give you effective protection.
I highly recommend you use PUTs over STOP losses when insuring your portfolio.
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Thanks for reading. Have an eclectic day!