Adjusting Option Trades - 4 Ways to Reduce the Risk on Your Option Trades

March 9, 2011 - PRLog -- Adjusting Option Trades

Trading stock options is essentially the trading of risk. And making money with options usually requires that you assume someone else's risk. But risk is a dial, not a switch, and just because you're willing to assume risk in order to gain compensation, that doesn't mean you must assume as much risk as possible. The trick is to find that balance between risk and reward that's right for you.

Here then are four areas where you can adjust your risk level beforehand when initially setting up an option trade:

1.) Adjust the Strike Price - Choosing a strike price is one of the more important factors determining whether a trade will be profitable. If you're writing naked or cash-secured puts, for example, the farther out of the money they are (the farther the strike price is below the stock's current price), the more downside protection you gain. You will receive less premium by doing so, but the more conservative the strike price, the more likely your trade will be successful.

2.) Adjust the Expiration Date - In some trades the more conservative move is to choose a near term expiration date, and in some trades it's to choose an expiration date farther out. For example, an iron condor is essentially a bet that a stock won't move outside a certain range prior to expiration. But the longer away expiration is, the more likely the stock will eventually trade beyond that range, either above it or below it.

And conversely, with a long call (which can be seen as the other side of a covered call where an investor gives up a large portion of potential capital gains for the security of receiving an immediate cash payment), the farther out the expiration date, the more time you allow your trade to become profitable. Get Internet #1 - Adjusting Option Trades @ http://tradingcure01.webs.com and be Successful forever!

3.) Add a Leg - Adding a leg to a trade can go a long way to reducing the overall risk you might otherwise assume attempting to set up a profitable trade. Take an extreme example - a naked call (which is very dangerous since the risk to the trade is theoretically unlimited). In exchange for a cash payment, you give someone else the right to buy the underlying shares from you at the agreed upon strike price. The higher the stock trades above the strike price, the more money you lose since you will first have to buy the shares yourself at the current market price (as opposed to a covered call where you already own the shares).

Adding a leg, however, transforms the naked call into a bear call spread. In this example, the trade is executed by buying a call at a higher strike price than the call you sell (the credit you receive from selling at the lower strike price will be greater than the debit you pay for buying at the higher strike price). You receive less overall net premium, but your risk with the bear call spread is limited to merely the difference between the two strike prices.

4.) Select the Underlying Very Carefully - Arguably the most important and most overlooked aspect to managing the risk you're willing to assume in your pursuit of profits is the selection of the underlying stock itself. There are two components to judging whether an underlying stock would make a good options trade: fundamental analysis and technical analysis.

If the risk you're assuming is the risk of actually owning the stock (e.g. writing puts or covered calls), you should honestly feel that the stock would actually make a good stand alone investment. Never be seduced by high premium to offer to buy stocks that you would actually hate to own.

Finally, technical analysis attempts to analyze short term trading indicators to determine a stock's most likely behavior in the near term. It's a difficult, and inexact, art to be sure, but that doesn't mean you should ignore it and blindly set up trades and then simply hope for the best.

Conclusion

Just about any option trade can be made more risky or less risky. Don't presume that you must take outsized risks in order to generate decent profits. Assuming less risk and smaller returns will undoubtedly improve the consistency of your trades, and that in itself may make you more money in the long term. Get Internet #1 - Adjusting Option Trades @ http://tradingcure01.webs.com and be Successful forever!

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