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.

Again, I will repeat, I always keep an inventory of Spyder Trust ( SPY) puts. For all other positions, make sure you have clear entry and exit points. I'll also repeat my belief that in option trading, strategy selection and overall position structure are of equal importance to stock-picking prowess.

There are very few individuals that can outperform the market over time by simply picking a handful of stocks. And when you are dealing with a decaying asset such options, then using the strategy and how it aligns with your short-term outlook and overall investment portfolio take on increased importance.

Realize that not every position will start in the plus column and that losses are inevitable in trading. No one ever likes to take a loss, but once you start backpedaling, it does not take much to be dealt a knockout blow and incur a large loss.

This is What it Sounds Like When Doves Cry

One of the first rules for controlling risk is to understand there is never a reason to be short naked options. There is no position that cannot be replicated as a fully covered position that has a limited risk. The cost of limiting your risk may put a small drag on returns, but you will never be put out of business by those "black swan" events that crop up from time to time.

That said, if you are sophisticated, well capitalized and understand the risk, there is nothing inherently evil about being short options. I would temper this statement by saying that at this point in my career, I will only go uncovered or have naked options if it is part of a multi-strike strategy.

That is I am willing to be short more contracts than I am long, only if the structure of the position is such that it would it be a very significant price move, somewhere in the 30% range, that would bring me to a breakeven point.

For example, if one sees a huge spike in implied volatility, then ratio spreads might make sense. Or if one believes IV might increase over time, using a calendar spread in which one sells short some "extra" of the front-month option might be a reasonable risk.

The difference between these type of positions that have a component that owns or is long an option whose strike is closer to the money than the options sold short, is that even in an adverse move, the losses will be significantly less compared to a position that is simply short or a naked a single strike price.

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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