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business newsStructuring an Option Portfolio
Options can fit into your overall investment and trading goals. Here's how.
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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're 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.
While recently it has been mostly bullish positions that have worked given the type of volatility that has occurred over the past two years, it's a good reminder to balance both bullish and bearish positions. If you're not keen on shorting individual names, then 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.
Taking a ShotFinally, 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.
But keep in mind that even speculative or flier-type positions should start with defined parameters with price limits for entry and exit points and a set stop-loss limit order in place once the position is executed, unless the risk is minimal.
Again, this reaffirms my belief in the importance of risk management, and also means you don't need to be tied to your computer all day. It also heads up the point that nothing goes up forever, making the notion of achieving unlimited profits a siren's song.
More often than not, such speculative plays will be losers, and by clinging to the position, you're increasing the probability that the losses will be 100% of the initial investment. Be prepared for this by having reasonable expectations in terms of profits and acceptable losses.
Keep Cash on Hand
Why keep nearly 50%, or $50,000, of risk capital sitting in cash? Unlike buying or selling common stock, which basically has an on-off switch, options trading is more dynamic and three-dimensional.
As the price of the underlying stock moves, it offers opportunities to make adjustments, which often involves expanding or adding to the existing options position. The key to producing consistent profits is having sufficient capital available both to defend and lock in profits when changes in price and market conditions occur.
The combination of starting with a defensive strategy in place and keeping available cash on hand allows you to withstand the inevitable drawdowns that occur in every portfolio, make appropriate position adjustments, and, most importantly, react and take advantage of volatile situations.
For the most part, trading options is about grinding out small returns on high-probability trades. But the biggest winners are usually contrarian plays. It's important to always have some ammo ready to make a stand when everyone else is panicking.
For more from Steve Smith, take a FREE 14 day trial to OptionSmith and get his specific options trades emailed to you along with exclusive access to his full portfolio. Learn more.
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