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Options Trading -- 10 Flexible Trading Rules to Remember

Posted August 25, 2011

Topics: Finance & Investing

Options are unique in the investment and trading worlds. These are the most flexible instruments you will ever find. You can design a strategy that is anywhere in between high-risk and ultra-conservative. You can set up a combination that costs little or nothing or even produces income. You can use options to reduce portfolio risk. Finally, options enable you to leverage capital and reduce overall market risks.

Here are 10 points to remember in picking an options strategy:

1. Double-digit returns are possible through speculation -- but so are double-digit losses. Remember, if your losses are limited to the cost of the option, a total loss is a 100% loss.

2. Double-digit returns are also possible in a conservative strategy. For example, a covered call is very conservative but, properly set up, it is difficult to avoid double-digit annualized returns.

3. Any strategy including long positions in stock should be based on smart stock selection as your first step. This means applying fundamental criteria and picking a strong dividend yield as part of the big picture.

4. More volatile (risky) stocks have higher option premium, which is attractive. But risk is risk, and picking stocks just based on option premium is a dangerous game.

5. You probably are not going to get rich quick with an option strategy. You might get rich slowly or, more realistically, you might have to settle for out-performing a stocks-only portfolio. A long stock and covered call strategy may produce a yield two to three times higher than a stocks-only portfolio.

6. Remember, annualized yield is valuable for comparisons between two or more options in a covered calls strategy. But this will not be the yield you will earn consistently.

7. Some option strategies are appealing because they are exotic. But it should be more appealing to use simple, easily understood strategies that are also profitable.

8. What works on paper does not always work in the real world. The only way to gain experience is by trying out strategies. Paper trading is a good way to start, but real experience is based on profits or losses using real money.

9. No one can advise you in picking the right option strategy. Options trading is an individual effort that you need to develop on your own. If you have to rely on a broker or planner to tell you what to buy or sell, you are probably not ready for the options world.

10. Finally, keep your base portfolio intact. Value investments or growth stocks, whichever you prefer, should continue to work as your core investments. Options can increase your income for minimal risk, insure paper profits, allow you to take profits without needing to sell stock, or let you speculate with a small portion of total capital.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches five  courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.”  He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to several blogs: CBOE, Seeking Alpha and the Global Risk Community.