Options are employed by a number of CFD traders as a type of guaranteed stop loss. Options have an advantage over guaranteed stoploss orders in that they are often cheaper. Hedging CFD positions using options is a common strategy utilized by more advanced traders that understand the core components of an option contract and are familiar with how to choose the most suitable contracts to hedge their CFD position with.
One of the arguments that is often advanced against using guaranteed stop losses is that you are charged for them whether or not they are needed. Although the percentage charged may not be large, the money is lost whether or not the trade ever dipped, let alone exited on the stop loss. You have to take out the guaranteed stoploss when you make the trade. In effect it is like paying an insurance premium. The usual advice about using GSL’s is to restrict them to financial securities that are particularly volatile where you might reasonably fear that a regular stoploss order might not be filled near the price level, for instance securities that might gap open at the start of the trading day.
Now it should be emphasized that using options instead is a sophisticated technique, and not for someone who is still learning about trading CFDs. Options are another derivative financial product, so in common with CFDs they are leveraged and capable of multiplying the money traded. The advantage that they have over most other derivatives is that, for the buyer of the option, exercising the option at the expiration date is a choice, and is only done when there is a profit to be made. While you pay a premium to own the option, your potential loss is limited to this amount.
The key to using options is that, although they present an option to buy or sell the actual stocks at expiration, they can be traded at any time up to the expiration, and their value depends on various factors. The intrinsic value is the difference between the actual stock price and the strike price of the option if it is in the money. The extrinsic value is based on the price volatility, making a more volatile stock potentially more valuable, although this is harder to quantify. The time value of an option is based on the time to go before the expiration date, and this value diminishes more quickly as the end date approaches.
There are some disadvantages to using options to cover any losses beyond a certain price level, effectively acting as a guaranteed stoploss. The chief one may well be that options trade in units of 100 shares. This means that if you have, for example, 50 CFDs, there’s no convenient way to match the hedging capability of an option to the value of the CFDs. The other is that the premium paid for the option is not refundable, and if the option expires worthless the money is lost. However, when using options to prevent loss in conjunction with CFDs, you should be looking for longer-term options so that the time value is fairly stable and not losing too quickly, so you should always have time to sell the option on.
