Individual investors have a tough time playing the downside in the market. Between margin requirements and account restrictions, not to mention the psychological barrier, investors have a difficult time shorting stock which is the only way for a stock trader to play the downside. Not so for investors who know how to use options. In a volatile environment an investor can easily play a down or bear market with the use of puts. An investor can profit in a down market buying a put as an offensive weapon to play a downside movement.

Even if an investor has not yet become comfortable with the idea of using options to play the downside to make a profit, an investor can at least use options to protect their profits and portfolio. Profit protection is the second advantage of options because options are the perfect form of hedge. Using puts to protect long stock positions and using calls to protect short stock positions is a much more efficient and effective way to hedge a position than diversification or even using stop orders.

Diversification is a very weak form of hedge. As you have seen in most significant downturns, everything goes down. Owning a little bit of everything (a la Mutual Funds) does nothing for you since everything goes down. A true hedge, like options, works for you regardless of what goes down. Options can also protect a short position against a stock going up. The key is that the option is directly tied to a particular stock, unlike diversification where there is no direct link between different stocks.

Stop orders do not work on gap openings, the time when investors need them the most. As investors, we do not mind the normal fluctuations and gyrations in the price action of the stocks we own, particularly over the long run. We know our stock will go up a bit and down a bit over the course of time and we are prepared for this inevitability. What really hurts investors is a large, catastrophic movement such as a stock losing 40%-50% of its value. This almost only occurs on a gap opening. And this is when you need your stop order the most. Unfortunately, this when stop orders do not work when we need them the most!

Stop orders become elected (activated) when the stock first trades at or below the stop price. While the market is open and trading, you get executed at a price that is near the stop price. This happens because the market is trading in a plodding, incremental movement - price through price. Once the market closes, the stop order is no longer working. It “sleeps” while the market is closed. Once the market re-opens, the stop order awakens. But at what price level?

Let’s look at an example. You own a stock (XYZ) that closes the trading day at $65 and you have a $60 stop order in. After the close, it is reported that (XYZ) is under investigation by the SEC. It seems the company has misrepresented its earnings in each of the last 4 years. Instead of small gains, it had large losses. It is anticipated that the stock will open substantially lower the next day. After a morning of more bad news, the stock opens at $40. Acting in accord with its definition, the stop order becomes elected on the first trade at or below the stop price. At the gap opening, the stop is elected at $40. You then receive a fill of your order at $39.50, the price of the first trade. What good was your stop order? What did it do for you? What it did was let you down when you needed it the most! Options do not do that. They work 24 hours a day, seven days a week. They protect you against gaps……the time you need them the most!