Question: A trader buys a stock at $30 and wants to limit downside risk. Which of the following orders will most likely guarantee that he can sell the stock at $25? (GTC means good till cancelled)
A. GTC, stop $25, market sell order
B. Put option buy market order with a strike price of $25
C. GTC, stop $25, limit $25 sell order
Answer: B
Explanation: Option contracts can be viewed as limit orders for which execution is guaranteed at the strike price. Therefore, a put buy order at a strike price of $25 will guarantee selling the stock at $25.
I can see how the answer could be B or C, but can someone explain to me the thought process they would go through to get to answer B over answer C. Doesn’t a limit sell order guarantee the price as well?
My opinion of it is that if you set a put option in advance with a strike price of 25, no matter what if prices go below 25 you will still be able to hedge all of your long stock losses with the put.
In a real world setting, I would think of B being more effective if markets open at $22 due to negative information being released before markets open. The GTC stop would then be enabled and the price would already be lower, therefore not giving you the 25, whereas the put would already be in effect since the day you enter the option.
Don’t quote me as I’m studying for the same test as you, so if anyone wants to confirm this that would be great.
A stop order is a conditional order, triggered by the underlying price reaching a certain level. In this example, the stop order would go into effect once the stock price drops to $25 or below. If after the trade that triggered the stop order the price continues to fall, a stop sell order with a limit of $25 would not be executed at prices below $25, so it could potentially never execute if the price never appreciates to at least $25 again. A market stop sell order at least would execute the trade no matter what, and in a liquid market, you could assume that the execution price would be very close to $25, but it cannot be guaranteed.