If you have ever taken a position in a stock, undoubtedly you will have heard about placing a stop on your shares to protect them from losing value. This is usually good advice, in general. But placing a stop will usually be set at the “market”. This means you will get the best price (read this as the best price for the market makers, not you!).
Especially, in a fast-moving market to the downside, it could go past your stop, and you will wind up losing much more than you would have initially intended. But there are better ways.
One way to place a stop is to buy a Put option, which will give you your price whether it falls beyond it a little or a lot! You have set your price and you won’t lose anything more. As an example, you own 100 shares of GameStop (GME).
The price or stock doesn’t matter, it will work for any underlying that has options.
If you purchased GME on the dip at about $175 from its most recent high of $223, you could protect the position by buying a put option a month or so out.
As you can see in the image, if you go down to a potential support area for GME at $166 (the red line), you could buy a Put at $165 for $10.50 or $1050 for the 100 shares. This is like buying insurance to protect your car and is the main reason that derivatives were created.
If it gets down to that level in the next month, you will sell your shares to the seller of the Put no matter how far below $165 the price moves. If it goes down, but not below your strike, you are down $1050 with the stock price loss.
This works great if the price drops down below the $155 price level because you won’t lose any more than if you just waited to sell it at $165 price.
This stop-loss strategy works pretty well in several ways. First, you don’t have to keep the Put on if you are no longer worried that GME will continue to decline. For example, if the price drops slowly to $170 and you change your mind and want to continue holding it, you can sell back the Put and close your position.