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The 6-Week Options Trading Kickstarter: Hedging, Portfolio Protection, and Avoiding Disaster

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Steve Smith discusses using options to protect your positions and portfolio.

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MINYANVILLE ORIGINAL

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.

No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

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