In what is now becoming a small series of articles on some option trading concepts that included this week's discussions on strategy selection and education, today I'd like to talk about asset allocation and how to use options to boost your overall returns.

As conventional wisdom says, diversification is the key to both building and protecting wealth. You are most likely familiar with the broad general rules of asset allocation, so let's move on to the next level and get straight to how options can fit into your overall investment and trading goals.

Depending on your age and total available assets, you should allocate only 10% to 20% of your total risk capital to an options-based portfolio. Let's assume you are fairly financially secure and can commit $100,000 to a strictly option-based trading account. Right off the bat, I'd say that one should typically have only half of that figure at work at any given time.

A Question of Balance

Of that $50,000, about 50%, or $25,000, is dedicated to hedged positions -- such as spreads that have both a limited risk and limited reward. These may be simple vertical spreads, or more complex calendar and butterfly strategies. About 30%, or $15,000, is dedicated to longer-term, directional positions.

And given the type of selloff that's occurred in the past month, remember to balance both bullish and bearish positions, or at minimum, keep some index puts -- whether they be on the Nasdaq 100, or its ETF, the

Powershares QQQ


or the

S&P 500

, which uses the

Spyder Trust

(SPY) - Get Report

-- in place to maintain broad market downside protection. Figure you can allocate about 5% of the option portfolio toward our next entry.

Taking a Shot

Finally, you can keep about 5% to 10%, or about $10,000, available for purely speculative positions, which might consist of using out-of-the-money options on earnings plays, takeover targets or news events.

But keep in mind that even speculative or flier-type positions should start with defined parameters with price limits for entry and exit points and a set stop-loss limit order in place once the position is executed, unless the risk is minimal.

Again, this reaffirms my belief in the importance of risk management, and also means you don't need to be tied to your computer all day. It also heads up the point that nothing goes up forever, making the notion of achieving unlimited profits a siren's song.

More often than not, such speculative plays will be losers, and by clinging to the position, you are increasing the probability that the losses will be 100% of the initial investment. Be prepared for this by having reasonable expectations in terms of profits and acceptable losses.

Keep Cash on Hand

Why keep nearly 50%, or $50,000, of the model portfolio's resources sitting in cash? Unlike buying or selling common stock, trading, which basically has an on-off switch, options trading is more dynamic and three-dimensional.

As the price of the underlying stock moves, it offers opportunities to make adjustments, which often involves expanding or adding to the existing options position. The key to producing consistent profits is having sufficient capital available both to defend and lock in profits when changes in price and market conditions occur.

The combination of starting with a defensive strategy in place and keeping available cash on hand allows you to withstand the inevitable drawdowns that occur in every portfolio, make appropriate position adjustments and, most importantly, react and take advantage of volatile situations.

For the most part, trading options is about grinding out small returns on high-probability trades. But the biggest winners are usually contrarian plays. It's important to always have some ammo ready to make a stand when everyone else is panicking.

Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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