An interesting approach of using stop loss by CFD traders is the use of options. Those instruments have the advantage of being cheaper than guaranteed stop loss orders. Using options for hedging purposes is a common used strategy among advanced traders. However, options are more complex that CFDs and other Over-The-Counter contracts and one should understand the core principles before using them.
The biggest disadvantage of guaranteed stop losses in CFD Trading is that fee applies regardless of whether they are used. The charge is not so high but the overall cost can increase with the number of stop losses used. For instance, if you trade with intraday or scalping strategies, the cost will be higher than if using options. In fact, paying a fixed fee per trade makes no difference with increased spread. So why, don’t save this cost by simply opening a position in options? On the other hand, the guaranteed stop losses are useful when the instrument is highly volatile and you fear that the regular stop loss order might not be executed. Another example is the morning market opening with a gap embracing your stop order; also it will not be executed.
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.
It should be clearly stated that using options is an advanced technique and requires deep understanding of the markets and mechanics of execution. There are not suitable for novice investors. If trying this strategy it is advisable to use it both CFD and Options demo accounts for at least a month and still take into account the slippage and requites you might get on real execution. In addition, both of those derivatives are traded on margin which imposes clear money management system in place in order to avoid unexpected margin calls and auto closes.
The key advantage of using options, however, is not the cost saving but the right to choose whether to exercise the option at maturity or not. Obviously, you will only do so if the option is profitable. There are also many types of options which can be widely used in strategies. Those are binary options, no-touch-options and many others. Also the options profits are not primarily correlated to the actual price of a stock but rather on its volatility. The higher is the volatility, the more profit opportunities.
There are some disadvantages of using options instead of guaranteed stop losses. The biggest one is that high minimum trading amounts are required. While with CFDs you can buy 1 share in some cases, the minimum lot is 100 shares. For example, if you have a position with 40 shares there will be not a proper way to hedge them with an option. The other major disadvantage is that the option has 2 possible outcomes – full loss or full win at expiry date. In this case the premium will be lost and non-refundable if the price goes in your desired direction.