Options pricing is not linear like Equities, Can you suggest a better way to set STOP LOSS for options?

General
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Options pricing is not linear like Equities.

In Equities, we could see support or resistance, yday’s low value etc to apply stop loss.
Intention is that stop loss should not get triggered for normal variations of the day.
It should get triggered only in case of big bullish or bearish trend shown by the underlying stock.

But the options price change a lot when the underlying stock changes slightly.
Hence, there comes a problem of my stop loss gets triggered even for a small change in the underlying.

Could you suggest a better way to put stop loss for options?

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I will tell you what I’m doing, this is not a foolproof method though. This is only time tested, and works with me. I don’t know whether you will agree on it or not.

I just keep a S/L based on Rupees and not on points/ticks, for eg. if I buy 2 lots of Nifty Index Options and I’m ok with risking Rs. 500/- (as my S/L), this calculation will be done in points to arrive at a figure (500/2lots= Rs. 250/- per lot) = Rs. 250/- /50 (lot size of Nifty Option) = 5 points for 2 lots and 10 points for 1 lot. Secondly, I buy Nifty Index Options which trade in the range of (Rs. 30/- to Rs. 60/-). I never buy anything below Rs. 30/- or above Rs. 60/-

As regards stock options, I don’t trade in them.

Waiting for some other people to respond to this question. So that, I will also learn something.

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Options behave very differently than traditional equities.

For all naked option positions, I personally do not like to keep stoploss based on option price...rather I'd base it on the spot prices.

For example consider I have bought 8000 CE at 34, when Nifty Spot is at 7990. My stop loss for this would be based on Nifty spot. If I have a 1% SL on Nifty Spot, i.e about 80 points below my entry (7910)..I'd hold on to my option position as long as Nifty Spot is above my SL i.e 7910.

At 7910 or below, I'd take a call to exit the trade (or whatever action) even though the option is trading at a much lower price than my entry. 

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You can use Option Greeks to estimate the approximate value of the underlying at which you may want to keep SL for options. Here are some calculations..

Assume:

Nifty Spot = 7990

Strike = 8000

Option Type = CE

Option Delta = 0.4

Option Price = 34

Lot Size = 50

Qty Traded = 1

Premium Paid = Rs.1700/-

Desired SL in Rupees = Rs.1000/-, this mean for the SL to be trigerred, the Option Price has to drop to Rs.21 from Rs.34...a drop of 13 points ( Rs.13 * 50 = 1050)

Now the question is, if the Option Price has to drop to Rs.21, what should be the corresponding value of he underlying?

Look at the Delta = 0.4

This means the option move 0.4 points for every 1 point movement in the underlying. Going by this a drop of 7 points on Option Price will happen when the underlying falls by at least 33 points. 

This means 7990 - 33 = 7957. 

Hence, 7957 will be corresponding value of spot if you wish to keep Rs.1000 as your SL (based on Option price).

Hope this makes sense. 

Also do remember, there are other variables at play (Vega, gamma, theta), hence I've used the word "approximate'.

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Since the risk you’re willing to take is in Rupees, there’s no point calculating SL based on the underlying’s price. Determine your Risk:Reward ratio and apply SLs accordingly. But it’s all very subjective. Depends on what kind of a trader are you? Are you scalping, do you hold positions for 30 mins to a few hours, or do you carry positions overnight? Each one will require a different strategy.

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Sorry, but this worries me!
Is it not possible to do some reverse calculations of option pricing model to arrive at a stop loss value based on the amount of my premium lost. Like you said we need to fix based on underlying’s movement.
Example I wish to set a stop loss say at 1000 rupees loss, Can I find out what would be underlying value corresponding to that 1000 rupees?

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Of course you can, that’s why we have the Option Greeks :slight_smile:
Editing my answer above to include the calculations.

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Yeah getting that calculation.
But for OTM options, the delta when Nifty is at 7990 is 0.4
Wouldn’t that vary when Nifty becomes 7965 or something, may be it becomes 0.3 or 0.2.
Is it possible to capture this kind of change in delta also?

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Yes of course :slight_smile: You need to check the Gamma of the option to capture variations in Delta.
Check this http://zerodha.com/z-connect/queries/stock-and-fo-queries/say-hello-to-the-greeks
and
http://zerodha.com/z-connect/queries/stock-and-fo-queries/application-of-option-greeks

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so what is your profit or loss ratio by this method?