February 9, 2009

Well .. you could be forgiven for wondering about the unusual title for this blog post. But you may recall in the last post I warned of the dangers of selling an option whether a call or a put, unprotected. The term for that is naked. Hence me varying the usual title of ‘how to trade options …”

For example, lets say I make the rather foolish ploy of selling  a call option, assuming I am allowed to do this. The reality is that short of exceptional circumstances, I would not be permitted to do so. But .. as a theoretical example…  Yes .. the potential exists to make  a very good profit if the price goes down (remember I sell a call option in the expectation that the share price will drop below the strike price)  but in the event of it swinging the other way .. I stand to incur literally unlimited loss .. why would I dare want to go there? Same thing applies on the puts side when the price moves in the opposite direction.

The secret is to hedge your ‘bets’. And that is done by placing ‘covered’ positions known as spreads. Remember that the share price cannot be in two places at the same time. So, if the intention is to sell a call option, such as was the case with the May 120 call illustrated in my last post, you would protect this with the purchase of another call at  a slightly higher strike price (say a May 125 call).  You sell the May 120 call on the basis that you expect the share price to go down but you purchase the May 125 call to ‘hedge your bet’ just in case the share price goes up. Because the share price cannot be in both places at once you will always be in profit on one side of the transaction. Yes, overall you may sustain  a loss, but it will be much less than if you had sold the option contract naked. And .. the potential still exists to make  a very healthy profit. Exactly the same thing applies on the puts side.

With the OptionSphere course we place spreads for both calls and puts, thus ensuring the best possible starting point for setting up our positions. Remembering thought the two inviolate rules of the market place that options and their underlying shares go  up and go down and that they expire, the chances are that at least with some of our spreads we will need to make adjustments .. to bring our positions back into line.  More about that shortly.

These vertical spreads form the basis for how we go about trading as a business. Specifically, although not exclusively, our focus will be on the sale of Iron Condors (two vertical spreads – one with calls, the other with puts) and the purchase of Double Calendar spreads (the purchase of a call and put in the ‘front’ month together with the sale of same in a subsequent month). Other types of spreads occasionally used  .. Single Vertical Spreads (more often than not with adjustments) and Straddles with Protected Wings. It is not important that you try and remember these terms right now though, just know that with whichever spread chosen there is a strategy in mind.

This multidimensional and multidirectional approach to options trading, ensures that we trade with minimal risk at all times, that we know the extent of that risk before we go ahead and put the position on, and it ensures that we learn how to trade options with confidence. Next post? An introduction to the Greeks!

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