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Automatic Stops


Todd has mentioned in several pieces how he "buys gamma to neutralize long or short positions in stocks". This basically means using options to create automatic stops, essential in maintaining discipline. Much of this is explained in Options 101, but I will go over a few examples to illustrate some nuances.

Let's compare two alternative strategies if one has a bearish view on the QQQ index; that it is at a turning point and should turn immediately down. The first step is to quantify the risk and determine the deductible. The QQQ is currently trading at $32 and based on your technical view, you have a price target of $28. One alternative is to simply short the stock: you are willing to risk $5,000 and believe the technicals are intact unless the stock breaks above $35. In this case you would short 2,000 shares. You can make $8,000 or lose $5,000 if you maintain a buy stop at $35 and cover the stock at your target of $28. Alternatively you can buy 43 of the QQQ August 32 puts at $1.15 for $5,000 (43 x 100 x 1.15). If the stock goes up, the maximum you can lose is your $5,000 (automatic stop) and if it goes to your price target of $28 you will make $17,200. This looks off the top as a better trade, but remember when buying options you are working against time: there are 37 calendar days and 27 trading days until the options expire. But the automatic stop of the options is slightly better than your stop in the stock: you can't change your mind in the options and you risk a gap in the stock where you can't cover it at 35 (small risk). If you decide that you need more time and instead buy the September 32 puts it will cost more: at $1.65 you can only buy 30 puts for $5,000 and your profit at $28 is only $12,000 (based on intrinsic value). This is what Todd refers to as "buying gamma". Shorter term options cost less (because of less time) and therefore have less "vega" (which roughly can be compared to time premium), and consequently more gamma (more bang for less bucks). Gamma in this sense can be viewed as leverage.

If you are already short 2,000 QQQ at $32 and want to create an automatic stop with options, you can buy 20 of the August 35 calls at $.20 for a total cost of $400. Your maximum loss is now $5,400, slightly higher than what you wanted, but now you have eliminated any gap risk and any chance that you erroneously decide to not cover the stock (lack of discipline). It is always a good idea to go through this process of comparing risk, payoffs, and deductibles when deciding on alternative strategies.
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