By: Steve Smith
It’s a well-known investment maxim that risk is correlated to reward. But when it comes to options it seems people are often making claims to both consistently hitting singles while simultaneously being home run kings. When option volatility spiked to historical highs in March it became a ‘careful what you wish for the situation” it was surfers always begging for bigger waves, but when they arrive the bash talk often heads to the safety of the sidelines.
One of the keys to navigating the big wave is not just an honest assessment of your skill level, but employing appropriate risk management. Right, now the stock market is entering into a sweet spot for active (not maniacal) traders. The VIX has settled into the 30% level—this where premiums are plump but not so fat the year fear things can blow up in your face at any time. For an option trader with a modicum and knowledge and a healthy understanding of risk, there are many great opportunities.
Dollars to Donuts
But first, we need to be clear on our terms. Returns must be based on dollars at risk. Too often people mix and match these terms to put their results in the best light. Meaning, if a call option they own increases in value from 50c to $1 they will tout the 100% return. But if it expires worthless they will highlight the loss was limited to just 50c or $50 per contract, not that it was 100% loss. Both of these are true of course but the varied emphasis can be misleading. But at least when purchasing options the accounting is fairly straightforward. The capital required and the risk are limited to the cost of premium paid for the position. This is true for the straight purchase of a single strike or spread done for a debit.
Because of the… Continue reading at StockNews.com
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.