Options Trading Strategies – what is the Risk vs what you think it is?

Over the hundreds if not now, thousands of presentations I have done around the World, the understanding of what is risk, versus what people think it is, has been a central theme to almost each and every one and in particular when it comes to Options Trading Strategies.
Earlier today, I did an interview with a finance journalist from the Straits Times, the major newspaper in Singapore and Malaysia. I have got to know the journalist quite well, over the past few years, as we have been busy in Asia and as I type, I am flying up there to host an Options trading Strategies event.
One of the central themes to the interview was the common misperception out there that “Options are Risky!” and over the course of the interview, I set out the case for what proved to be the actual opposite.

Options are flexible

One of my senior traders was quoted not so long back as saying “options are the thinking man’s derivative” and this is a great truism. Options offer more flexibility than any other trading instrument out there – for example this little list of outcomes:

• Manage risk
• Protect or insure your shares
• Generate regular income
• Provide a profit from a rising market
• Provide a profit from a falling market
• Provide a profit from a sideways market
• Provide a profit from a wildly volatile market
• Unlock cash-flow from holding shares
• Enable underwater shares to be back to break even more quickly
• Directional plays up and down
• Allow you to target time decay and simply get paid for selling time
• Allow you to target volatility – buying or selling it, depending on your view
• Allow you to target differentials in performance between specific stocks
• Allow you to lock in a defined level of risk on the outset of the trade

All of these strategies have very limited and definable risk. Two options strategies that don’t – carrying an unlimited liability are two that we don’t promote – selling naked calls and puts – why? Because they carry virtually unlimited liability and their risk is off the charts.

But you have to watch the market all day to profit from options?

Um, no. Unless you are a trading junkie (apologies to those that are) there is a bit more to do with life, than simply watching the market all day. In fact the more you watch it, the chances are the less you will make!
The idea of investing is to generate cash flow, to provide choice and control – over how you spend your time etc and the strategies listed above are, for our clients, largely passive, thanks to our position management rules – when the target is hit – be that for profit or stop, we will exit the trade so no need to be watching and waiting and watching….

How about some diversification?

Great point – and within a portfolio, having several options trading strategies running across several stocks provides great diversification. For example, the bulk of your portfolio eg 80% of it may be sitting in covered calls. Why? Generating cashflow of course. But more importantly its at the lower level of the risk spectrum – and to be more precise, less risky than simply owning the shares.
Also, within your covered call holdings, there can also be diversification – not just simply across different stocks (having 4 banks in your portfolio is not diversification) but instead across stocks in a couple of sectors. Additionally, the actual call writing may vary too – for example if you are looking to simply generate maximum income, selling at the money call options would enable you to generate a big premium income.
Yet you may have a couple of stocks where your outlook is more bullish – and hence you may be selling out of the money call options – so as to generate some income from the option sale, and some capital growth in the stock. Sounds better, right – until you consider that by going further out of the money, your rate of return will be more volatile – perhaps something you are not looking for (not sure what this means, ask us about our Options Mastery Education).

And then a couple of extra strategies!

Maybe your view is the stock will hover at around within a trading range – and you want to get paid for your view on this – hence the Iron Condor may be just what you are after. This is the use of a Bear Call and Bull Put spread, two credit spreads one high, one low, meaning that both cannot go wrong – one can at worst, and chances are, the stock will sit in the middle anyway so both trades pay off! Again, this is the sort of thing that we teach and coach within Options Mastery, our advanced options program. While this may not be for everyone, it reflects just how powerful options as an asset class can be. We have a couple of these trades on the books right now – so its not theory, this is for real