Conservative Option Trading: A Simple Approach
Success in the stock market depends on many things and those who
have learned how to consistently profit in this game are few and
far between. There are numerous approaches to determining market
direction including: charting with technical trend or momentum
indicators, contrarian systems that use sentiment indexes or put
and call ratios, and valuation techniques such as fundamental
analysis. One of the most important issues that new investors
overlook is, regardless of the method, the stock market is very
difficult to predict and the value of time spent trying can often
outweigh the gains from the outcome.
We all use different systems to determine when to buy and sell
specific issues (most of them based on technical analysis) but
to profit with directional option trading, a trader must correctly
predict the movement of the underlying issues as well as the time
frame in which the move will occur. A successful trader must also
have a solid understanding of implied volatility in order to enter
the position at a fair price and determine a reasonable goal for
the outcome of the play. Even with the best techniques, this type
of trading involves above average skill and timing, including the
initial selection of the position (and its size) along with risk
management in identifying target exit points and the correct use
of stops to preserve capital. To complicate matters, some experts
suggest that success from directional strategies can be virtually
impossible on a regular basis and the inconsistency of returns
will prevent all but the most wealthy traders from surviving the
short-term losses.
With all of the difficulties involved in directional trading, are
there any techniques that offer the average investor a reasonable
opportunity to profit in a comfortable, low maintenance strategy?
We believe that writing covered-calls fits this description quite
successfully. A strategy based on stock ownership is much easier
to manage on a day to day basis than directional trading and it
offers a favorable balance of risk versus profit potential for
those who attempt to predict stock movement and magnitude. The
strategy is more conservative than just buying stock, due to the
fact that a premium is collected, lowering the break-even price on
the stock position and the concept is attractive to the investor
who is willing to limit his upside potential in exchange for some
downside protection. In addition, the technique is well suited
for individual retirement and Keogh accounts.
Investors that hold large positions in a specific stock can choose
a form of risk/reward diversification by spreading the sold calls
over time as well as different strike prices. A trader can gain
several benefits by writing a portion of the calls near-term and
the remaining calls further in the future. In the event of large
stock price fluctuations, all of the various positions will not
need to be adjusted at the same time. This activity may include
either having the stock called away, or buying back a particular
written call and selling another. Another advantage is that the
level of option premiums may become more favorable than when the
original series of calls were written. At worst, only one group
of options would be sold when the premiums are low and hopefully
they would increase in value before the next expiration period.
This type of diversification will also allow an investor to own
various positions at different prices, smoothing the portfolio
balance as the market fluctuates cyclically. This also prevents
all of one's stock from being committed at a single price. With
these unique combination positions, the covered write offers an
excellent balance between potential return and favorable downside
protection.
Although this strategy might not be suitable for everyone, many
investors will find the technique fits their comfort level and
lifestyle much better than other stock option strategies.
Good Luck!
Site Last Updated Sunday, November 11, 2001. 10:58:03