Staying in the Options Game

When fresh ideas are harder to come by, return to simpler strategies.
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Although the S&P 500 Index has been bound within a 5% range since the beginning of the year, this constriction belies the huge moves not only in individual names but in some broad sectors as well. The Nasdaq has covered more than twice that range, expanding its trail by 12.5% over the last four months, showing that there are profits in short-term price fluctuations and that the market may be coiling out to a new expanded range.

I've recently written several articles that suggest some strategies that hopefully cover several bases for the upcoming months, such as

last month's job's number, the likelihood of a

sideways market and positions that

take advantage of low implied volatilities and prices that will move above or below current levels a year from now.

These positions are currently profitable and have an improving risk/reward profile as times moves on. And although you can't earn a living by the past, I have to admit I'm currently at a loss to identify a singular distinctive strategy that seems to make the most sense right now. It's at these "option trader's block" times that it seems good to review some choices for trading options.

You Got Game?

When performing at their peak, great athletes have been known to describe the action as occurring in slow motion and in a general expansion of time and space; for example, seeing where all the players will be before they get there, or a basketball hoop seemingly expanding in size.

Because options tend to dampen the impact of daily price dips, one way for traders to increase their field of vision is by trading these derivatives as opposed to the underlying stock. "I spent 20 years in the S&P 500 futures pit; now I focus on both individual and equity options, and I feel like I'm trading in slow motion," says Philip Yarsley, a Chicago-based independent trader. Yarsley says options allow him to see the bigger picture and make more objective decisions. This, of course, is the opposite of what can happen in a panic situation, when everything rushes by you in a blur.

The trade-off is that with options there are more components to manage, such as all those "Greeks," and having to determine what impact a drop in vega, an increase in delta or the curve of theta will have on your position.

But this also helps create a more analytic approach to trading. Trading rules are good and necessary, but there are different criteria for different situations.

At last week's Optionetics

seminar, the presenter was adamant about advising people to buy options with at last 90 days remaining and exiting the position 30 days prior to expiration. This may be fine for some, but it certainly excludes a lot of strategies that reduce the flexibility that makes option trading so attractive.

A lot of option traders prefer to trade near-term options and gain leverage from lower-priced options or take advantage of the acceleration of time decay. Bernie Schaeffer, the CEO of Schaeffer's Investment Research and the author of many options books and newsletters, refers to these short-term speculators as "baseball traders," since they are usually swinging for the fences. He points out that even if you strike out often, or lose 100% or your maximum risk, as long as you knock one 300%-gainer out of the park for every two strikeouts, you'll wind up with a 33% return. Of course, this isn't something I'd suggest but simply a reminder that different strokes appropriately applied by different folks can get both into the Hall of Fame.

Spreading Game Management

As I said, I'm currently lacking a new compelling strategy to immediately implement, so I'm falling back on the fundamental vertical spread. This consists of buying (or selling) options with one strike price and selling (or buying) an equal number of options with a higher strike price but the same expiration date. The attraction of this position is that since you are both buying and selling options (either puts or calls), you're eliminating much of the need to gauge the Greek variables of the option position, such as vega risk (the possibility for a dramatic change in implied volatility) and theta (time decay), while retaining a limited-risk profile.

For example, with

General Electric

(GE) - Get Report

currently trading at $30.15, you could buy the May $30/$35 call spread for about 70 cents (which represents maximum risk), providing for a maximum profit of $4.20. Or you could sell the May $32.50/$30 put spread for $1.90 (representing the maximum profit), which provides a limited risk of 60 cents. The former offers a much better risk/reward, while the latter provides some advantage of time decay on a moderate move higher. But I would not consider this a home-run stock.

Instead, I would look out further in time to the September expiration and see that the $30/$35 call could be purchased for a net debit of $1.45, allowing for an additional four months in which the position could provide a 245% return.

Vertical spreads can be used in bullish or bearish formats and over short- or long-term time frames. They are certainly no slam-dunks or home runs, but they're a nice way to stay in the game.

Steven Smith writes regularly for TheStreet.com. 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 invites you to send your feedback to

steve.smith@thestreet.com.