It's All Just Paper Anyway

One thing you might consider is doing some paper trading, whether it be through a mock account with a broker such as OptionsXpress or simply tracking the OptionsAlert Newsletter. This will help you gain a better understanding of what strategies make sense and meet your comfort zone in terms of size and risk, and it will let you see how trades are executed and the impact of costs on returns. I've written previously on the benefits and drawbacks of paper trading .

Finding a Way to Unwind

I enjoyed your article on a ratio spread on Valero. The part I am trying to understand is how to protect against the unlimited risk if the underlier goes too high. In the Valero example, $114 is the break-even point. At what point would you unwind this position and how would you do it?

Thanks,
Tim

Tim, we all unwind in different ways; there's no one right way to trade. This includes both deciding what trades to initiate, and subsequently, how to take a graceful and hopefully profitable exit. Ratio spreads, like the one described in the article you reference, carry potentially unlimited risk, so it's absolutely necessary to devise an exit or stop-loss point.

As the article suggests, I like to use break-even price levels as a first point of reference. In the Valero Energy ( VLO) position (a $95/$105 one-by-two call spread, which is a trade we executed in the OptionsAlert model portfolio), the $114.75 break-even point was used as an initial trigger for closing the position. One thing to note is that this price represents break-even at expiration. This means that depending on the time remaining and implied volatility awarded to the options, the position will show a loss before expiration even if the share price is below the break-even point. Because the downside risk is limited to the cost of the spread, and it is a speculative position, I don't find it necessary to initially establish a downside stop-loss level.

One approach that I like to use as expiration draws closer is to tighten the stop to price levels below the break-even, which, if triggered, would still result in a profit. Ultimately, one hopes that the share price gravitates toward the maximum profit point, which in the Valero example would be realized at $105 per share.
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 appreciates your feedback; click here to send him an email.

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