Options: Back to Basics

The following blog entry was originally published Jan. 7 at 1:05 p.m. EST

Stocks have done a little dipsy-do during the first half of the day which has allowed me to nibble on some calls, a little tech and a little health care, as I discussed in this morning's post. Otherwise, it looks like trading is going to characterized by nervousness, as the S&P 500 hovers above the 1400 line. With the markets entering a relatively quiet lunch period, maybe this is good time ramble a bit on some broad option-trading concepts.

Learn the Basic Option Strategies

Let's assume you've done some basic homework and know the general principles of options. It's time to investigate various trading strategies. For instance, do you know that an at-the-money spread benefits from a decline in implied volatility, while an out-of-the-money spread benefits from an increase in implied volatility?

Do you know the difference between credit and debit spreads? Do you know that a covered call is often promoted as conservative, but selling naked puts is considered extremely risky, even though these two strategies offer the exact same risk/reward?

The lesson here is to know which strategy works best under various circumstances so that you can choose the one most appropriate for your risk/reward threshold and that best aligns with your investment thesis. If you just want to buy cheap out-of the-money calls looking for a big "lottery ticket," the odds are stacked against you making money over the long term.

The Great Deodorant?

Winning has often been called the great deodorant in which personal conflicts or other problems get covered over. But to help prevent needing to bring out the Right Guard, another well-worn sports analogy remains true here: Defense wins championships. That means never leaving yourself exposed to unlimited losses. Or losses that leave you unable to meet a margin call (if a position is losing money, you have to add additional capital to your account, or it will be forced to close the position). Once money rather than market conditions becomes the focus of your trading decisions, your investment thesis and discipline get tossed out the window, and you operate from a position of weakness.