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 ( QQQQ) or the S&P 500, which uses the Spyder Trust ( SPY) -- 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.