Options for volatile stocks

08/13/21
  • NTES has consolidated in recent days after huge volatility surge
  • Stock plunged as Chinese regulators cracked down on tech companies
  • Price action highlights different ways to potentially manage risk

The  volatility triggered by China’s recent regulatory push is in full view in a chart of online gaming, music, and e-commerce stock NetEase (NTES), which plummeted 27% in three days in late July, testing its March 2021 lows and completing a roughly 50% retracement of its September 2018–February 2021 rally:

Chart 1: NetEase (NTES), 4/16/18–8/12/21 (weekly). NetEase (NTES) long-term price chart. Breakdown and bounce.

Source: Power E*TRADE (For illustrative purposes. Not a recommendation.)


Although there’s a wide range of opinions regarding the possibility for continued fallout from China’s regulatory push (Morgan Stanley recently posted a brief podcast on the topic, in addition to a bigger-picture look at the Chinese equity market), the one thing everyone can agree on is that it isn’t currently a market for the faint of heart.

But it does highlight different ways traders think about controlling risk in such environments.

Responsible risk management would call for some type of hedging on any trade—for example, placing a stop-loss order below the market after going long. For the sake of argument, let’s assume a trader thought a stock like NTES had a good chance of rallying from this point but, given its recent volatility, also believed it could pull back and test its July 27 low ($82.50) along the way; any significant breakdown below that low would be the signal the bullish outlook was incorrect and it was time to get out of the trade.

Placing a stop-loss order somewhere below the July low would likely be the first thought that pops into a trader’s head, but the daily chart below shows what can happen if a trader picks a stop level that’s just a little too tight. If someone who was long NTES in July had a stop-loss order to sell below the low of the stock’s October-December 2020 consolidation—for example, at $82.75—they would have been stopped out on July 27 when the stock fell as low as $82.50 intraday but rallied to close at $88.32—and then jumped as high as $106.18 over the next four days:

Chart 2: NetEase (NTES), 11/3/20–8/12/21. NetEase (NTES) price chart. Testing the lows.

Source: Power E*TRADE (For illustrative purposes. Not a recommendation.)


You could certainly argue that any trader who placed a stop-loss order with so little wiggle room deserved to get flushed out of the market, but the reality is that there is no “perfect” stop level—place it too close and you increase the odds of getting stopped out, place it too far away and you take on excessive risk. For example, traders who bought NTES more recently and placed a stop-loss order at $80 ($2.50 below the July 27 low) may be giving the position five times as much breathing room as the previous example, but they still can’t guarantee not getting knocked out of the market during another volatile intraday sell-off.

By contrast, buying a put option with a strike price at the stop level ($80, using the above example) hedges the position just like the stop-loss order, but without the risk of getting taken out of the market on a brief move below the stop price.

Of course, that potential advantage comes with a price tag—the cost of the put option. One way to think of this approach is that your stop-loss level gets lowered by the amount of the put premium: If a trader paid 1.40 for an NTES $80 put, for instance, the effective stop level would be $78.60. On the other hand, there’s also the chance that, if the stock hits your profit target or otherwise moves far enough in your direction, you may be able to recoup at least some of your costs by selling the put.

It’s a trade-off. But especially in highly volatile markets, using options instead of stop-loss orders is one that may be worth it for some traders.

Note: NTES is tentatively scheduled to announce earnings on Thursday, August 19.

Market Mover Update: Communications tech stock 8x8 (EGHT) topped the unusual options volume list yesterday morning, trading more than 38,000 contracts—nearly 83 times its 460-contract average. Here’s the breakdown: 9,500 contracts each of the August $25 calls and $25 puts expiring a week from today. A possible straddle? If so, it may have been a case of a position being rolled forward, since 9,500 contracts also traded in both the September $25 calls and the September $25 puts.

Today’s numbers include (all times ET): Import and Export Prices (8:30 a.m.), Consumer Sentiment (10 a.m.).

Today’s earnings include: Honest Company (HNST).

 

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