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Option Basics: Risk and Diversification

The winners in option trading are those who manage the risk within their portfolio.  You must always monitor and protect your capital as if you lose your capital you will be out of the game.  Proper risk management starts with trading diversification and discipline to stick with your trading plan.

There are generally two types of portfolio risk: systematic and unsystematic.

Systematic Risk, also called non-diversifiable risk, is risk that cannot be eliminated.  It arises from factors which cause the whole market to move up or down, and can not be eliminated by diversification because it affects all securities. Examples of systematic risk are political or sociological changes that affect all securities.  Some of the most common forms of systematic risk are changes in interest rates or inflation.

Unsystematic Risk, also called diversifiable risk can be reduced or eliminated by diversifying your portfolio.  Unsystematic risk is risk that is unique to a certain industry, firm, or company.  Examples of unsystematic risk include: a company’s financial structure, weather and natural disasters, labor strife and a shortage of raw materials.  Since unsystematic risk affects a single company or industry, it can be mitigated by investing in many companies across a broad range of industries.

Option positions should be diversified.  A major advantage of option purchases is ‘truncated risk’, whereby your loss is limited to your initial investment yet your profit is virtually unlimited.  Option sells have a limited profit but should be diversified across several investments.  Diversification will allow you to use truncated risk to its maximum advantage.  While some of your positions will inevitably be  unprofitable, each profitable trade can offset several unprofitable trades. Option positions should be established among many underlying stocks and indexes in unrelated industries. This gives you diversification, which can help mitigate sector weakness.


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In order to trade options, your broker must first approve your account for option trading. There are various levels of option trading and each level has financial requirements that differ from broker to broker:

Level 1: Covered call writing
Level 2: Call and put purchases and covered put writing
Level 3: Spreads (requires margin)
Level 4: Uncovered call and put writing (requires margin)
Level 5: Index option writing (requires margin)

Be sure to ask your broker about their requirements for the level of options you plan to trade. Lastly, before you trade options, regulations require that you read Characteristics and Risks of Standardized Options prepared by the Options Clearing Corporation (OCC) and available from your broker.

Characteristics and Risks of Standardized Options prepared by the Options Clearing Corporation (OCC) and available from your broker.

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Compounding Returns with Option Selling

You have undoubtedly heard it said before – compounding returns is the eighth wonder of the world or man’s greatest invention. But to an investor it is a great wealth builder. While many income investors think of compounding dividends, this can also be accomplished by option sellers by compounding the option premium received by selling either put or call options. I think about the premium received as soon as the option is sold can be readily reinvested or compounded immediately.

Here is the formal definition from Investopedia:

Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest,” and will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount. The rate at which compound interest accrues depends on the frequency of compounding; the higher the number of compounding periods, the greater the compound interest.

The “Rule of 72” is an easy way to calculate how long it will take to double you money based on compounding returns. For example, an investor has a dividend stock paying an annual 5% dividend. Using the rule of 72, dividing 72 by 5 indicates the investor will double his money in 14.4 years. Not bad for a dividend producing asset. Now, let’s compare this to selling options. If you make 2% per month on average, you can double you money in 36 months (72/2=36). This is only 3 years compared to 14.4 years for the 5% dividend stock! Which investment do you want to pursue?

This is the theory behind our strategy to sell puts and covered calls at get rich investments. We can generate consistent income on a monthly basis that will provide us the opportunity to compound our money and returns at a faster pace than the buy and hold dividend investing.

Learn how to compound your money and the best stocks to use in this strategy to double your money.

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When To Take Action with Covered Calls

The basic covered call trader will write a call and wait until it expires then decide what action to take next.  I suggest that you monitor your position and determine what changes to make before expiration to enhance your profit or decrease your downside risk.

For the call writer with less time who does not have the time to monitor the position, you have 2 options to negotiate the market action:

  1. Determine the price you want to close the position and then set an automatic stop order.  For example, you entered a covered call and you do not want to let the stock decline so you enter a stop order to but the sold option at market and then sell the stock with both events triggered by your predetermined stock price.
  2. Let the option go until expiration and then make your next move.  This strategy does not mean you will lose money but you will keep selling calls to minimize any stock price decreases over time.

Now, for the more active covered call trader, here are 2 actions to increase your trading profits:

  1. If the price of any option you sold declines to a small amount, then buy the option back to lock in profits on the option.  If the option price drops to 25 cents per share or less, then you can buy it back with the different between sold option price being a profit.
  2. The second option is to watch the time value of an in-the-money option and buy it back when the time value gets low.  the rationale is that you have made most of the profit already as time value can only go to zero.  If there is only 10 or 20 cents left, you can buy to close and sell another option for more premium income.

There is no right or wrong strategy based on these two methods to trade covered calls.  You should decide if you fall into the first scenario (less monitoring) or the second (more activity) based on your time commitment to your covered call trades.  In a later post, I will discuss my way of trading covered calls based on a strategy that takes option obligation and stock price into consideration.

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