Combined Techniques: Creative Risk Management

Options strategies are varied and flexible and run the gamut from highly speculative to extremely conservative. This explains a large part of the appeal of options, even when employed as portfolio management tools. You can insure paper profits, take advantage of short-term price swings, or create double-digit returns with covered calls.

Beyond these popular and effective strategies are many additional ways to use calls and puts: in long or short positions or combined within single strategies.

This article demonstrates how many of these advanced strategies work and how you can create limited losses in combinations of many kinds.

Remember, however, that most examples are based on the minimum number of open option positions. The possibilities only expand once you begin trading in multiple numbers of contracts. This is limited by your imagination and risk profile. It also will be limited by margin restrictions imposed by both the Federal Reserve Board's regulations and the policies of your brokerage firm. Because of these limitations, you are required to keep a portion of exercise values in your portfolio at all times, which also limits the number of open option contracts you can have in your account. The many combined and advanced strategies open many doors, but you are always limited by your own financial resources.

Options traders can employ only four basic strategies: buying calls, selling calls, buying puts, and selling puts. But these four basics can be combined in numerous strategies; for example, you can modify risks in long positions with offsetting short positions in options.

Your reasons for buying or selling options define the level and degree of risk that you are willing to assume. The utilization of options defines your risk profile as a stock investor. Any strategy has to be secondary to the more important phase in your investment program: the selection of stock. A lot of emphasis is placed on option risk or reward, but the stock risk is easily overlooked. Before even considering how or whether to employ options, you need to first identify a strategy that helps you select stocks with several important investing rules in mind, including the following:

This short list only defines the overall importance of selecting stocks as a starting point in your program, and that may or may not include options. The big mistake is to pick stocks to cover rich-premium options and, in the process, unintentionally fill your portfolio with highly volatile issues such that any downturn in the market is likely to cause a severe loss of value in the stock. In that situation, a limited short-term option profit is accompanied by a larger loss in stock value and, potentially, problems recapturing value through a reversal in direction of price movement.

Smart Investor Tip

Avoid filling your portfolio with high-risk stocks picked because option premiums were higher than average. You need to watch not only potential profits on options but potential losses on stocks as well.

You have the right to decide individually how much risk exposure is appropriate. Applied to the options market, defining risk levels also helps you to decide whether a particular strategy is right for you. Consider the difference between one investor who wants only to profit from buying and selling options, and another who covers calls with shares of stock in order to maximize returns. The risks are on opposite sides of the spectrum, and the different uses of options by each person define and distinguish their perceptions of risk and opportunity, their desired outcomes, and even their basic ideas about how to operate within the market.

In moving beyond the four basic options strategies, you may discover value in a variety of combinations, which can be put into action for many different reasons. For example, long and short option positions can be engaged in at the same time, so that risks offset one another. Some combined strategies are designed to create profits in the event that the underlying stock moves in either direction; others are designed to create profits if the stock price remains within a specific range.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2020. Content published with author's permission.

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