Question

An expiring put option will be exercised and the stock will be sold if the stock price is below the exercise price. A stop-loss order causes a stock sale when the price falls below some limit. Compare and contrast the strategy of buying a put option to the strategy of issuing a stop loss order.

(Hint: assume you own 100 shares of stock. Consider the payoff to each strategy for different prices. Don't forget the cost of implementing the strategy.)

Answer 1

Stop Loss is a traditional method of reducing the losses you would incur, it places a limit on the stock prices below which the stop loss order becomes a market order, however you're never sure of the price at which your shares would be sold. The only redeeming point of stop loss orders is that you don't incur a cost. For Put options however, you have to pay a premium. But in a Put option you're sure of the price at which you shares would be sold. Put options have inherent risk management capability, Stop loss is more like an emergency measure.