Theory and Practice of Combined Techniques
Advanced option strategies expose you to the risk of loss, which could be significant especially when short positions are involved. If you do decide to employ any of these strategies, remember the following seven critical points:
- Brokerage fees are part of the equation. Transaction fees reduce profit margins significantly, especially when you are dealing in single-option increments. A marginal potential profit could be wiped out by fees, so approach advanced strategies from a practical point of view.
- Early exercise can change everything. Buyers have the right of exercise at any time, so whenever your short positions are in the money, you could face early exercise.
- Potential profit and risk are always related directly to one another. Many options traders tend to pay attention only to potential profits, while overlooking potential risks. Remember that the greater the possibility of profit, the higher the potential for losses.
- Your degree of risk will be limited by your brokerage firm. As long as your strategy includes short positions, your brokerage firm will restrict your exposure to riskâbecause if you cannot meet assignment obligations, the firm will be stuck with a loss.
- You need to thoroughly understand a strategy before opening positions. Never employ any strategy before you understand how it will work out, given all possible outcomes. You need to evaluate risks carefully, not only for the most likely results but for the worst-case possibilities.
- Using LEAPS options vastly increases the flexibility of combinations. Combination strategies can also be designed to avoid exercise risk or naked option writing risk, by employing longer-term LEAPS options. A net debit position could be transformed into a net credit position with repeated short-position offsetting sales over as long a period as three years.
- It doesn't always work out the way it was planned on paper. When working out an option strategy on paper, it is easy to convince yourself that a particular strategy cannot fail, or that failure is only a remote possibility. Remember that option premium changes are not completely predictable, and neither are stock prices.
Options add a new dimension to your portfolio. You can protect existing positions, insure profits, and take advantage of momentary opportunities. However, every potential profit is associated with an offsetting risk. The market is efficient at least in that regard: Pricing of options reflects the risk level, so while a price is an opportunity, it also reflects exposure to the inherent risk in opening a position. Only through evaluation and analysis can you identify strategies that make sense for you, that protect your stock positions, and that you believe have a reasonable chance of producing profits at risk levels you are willing to undertake.
Paper Trading: A Test Run of the Theory helps you test out strategies without putting money at risk. Even the most complex options strategies may contain risks you cannot always anticipate. By first going through the exercise of setting up a model portfolio and then paper trading (moving through transactions without any money at risk), you can try out any strategy and gain trading experience.
By Michael C. Thomsett