The 6-Week Options Trading Kickstarter: Hedging, Portfolio Protection, and Avoiding Disaster
Steve Smith discusses using options to protect your positions and portfolio.
Editor's note: To help investors get their feet wet with options trading, Minyanville has launched this "6-Week Options Kickstarter," an educational series aimed at increasing understanding of the basic nuts and bolts of options. In this series, veteran options trader Steve Smith will take you through options fundamentals with an emphasis on real-world applications. If you are new to the 6-Week Options Kickstarter series, we recommend starting at the beginning with What Are Options, and Why Should We Care About Them? Note: Intermediate or advanced-level traders will get more mileage out of Minyanville's 9 Weeks to Better Options Trading series.
When writing as an options educator and something of a proselytizer I try to keep in mind the Hippocratic Oath of doing no harm. So to avoid turning our little bit of knowledge into the roots of financial self-destruction, we'll go through some tips that can help you avoid blowing yourself up. And then we'll look at some ways options can be used to protect your positions and portfolio when outside forces turn against you.
- Understand what you are trading. Do not use products you are not completely comfortable with. Review the contract specifications, such as size, assignment style, dividend dates, and settlement process. In recent years, there has been a tremendous proliferation of products; for my part, I avoid trading those related to the VIX (^VIX), or that are leveraged or inversed.
- Understand leverage. As discussed in the principles of options trading article, leverage can cut both ways. The first and most important rule is to never base the number of options contracts you are buying or selling on the notional value as you would with stocks. Do it on a share or delta basis. For example, if you are taking an options position based upon the expected movement of $5,000 worth of stock (say, 100 shares of a $50 stock), do not buy or sell $5,000 worth of options -- rather, use the number of options contracts that will give you exposure to those 100 shares.
- Limit risk of positions. Never sell an option naked or uncovered, which can carry unlimited risk. For example, to take a bearish position on Apple (NASDAQ:AAPL), it would be extremely risky to do something like sell the October $630 calls for $11 with the stock trading at $625. Let's say investors got excited about the new iPhone, and sent Apple higher. After it hits $641 ($630 + $11), the losses start adding up quickly. If the option expired with the stock at $650, the option seller would incur a $900 loss ($650 - $641) per contract. And at $660, it would be a $1,900 loss. If you want to sell or collect premium, use a credit spread to limit the downside risk. Buying an option will limit your risk to its cost.
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