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The Versatile Stock Option

As the market approaches new all-time highs (S&P 500 Index), it’s natural to want to ride the gravy train. Of course we never know whether the bull market will continue, fade slowly, or disappear. The beautiful thing about trading options is that we can adopt any type of strategy and limit our losses at the same time. No one expects the stock market to open lower by 20% one not-so-fine day, however instead of getting hurt in such a black-swan scenario, even bullish traders should be able to walk away without too much pain.

For that reason, it is important for option traders to recognize what they are trying to accomplish and to own positions for which both potential reward and risk are acceptable. Options are the most versatile investment tools around, and can be used to micromanage any investor’s portfolio. Be sure to manage risk.

    –Aggressive bulls probably own naked long calls, while others own call spreads. Either strategy may be working well — if those traders held on, or re-loaded during the end-of-January market decline. Success also depends on how skilled these traders are in selecting good options to own. Many times the traders buy options that are too far out of the money and never earn a dime.

    –There is not much we can say about aggressive bears. Unless they took a quick profit a few weeks ago, the market has not behaved well for them and the only good news is that bearish strategies come with limited loss. Any bearish trader who was mindful of the importance of risk management should be unhappy, but not financially hurt.

    –Market-neutral traders made or lost money, depending on the strategy chosen. This market may be quite non-volatile from a day-to-day perspective, yet the moves have been devastatingly large for owners of iron condor or ATM butterfly positions. However, straddle buyers and back spreaders probably performed very nicely. Once again, the choice of which specific options to trade played a big role.

Some people in the options world like to repeat the phrase: “You can use options to make money in any market; bull, bear, or neutral.” This is a true statement. However, the most important part of the truth has been omitted. The sentence should also include “as long as you position yourself correctly for the next market move.”

Regardless of your market outlook and the strategy you choose to play, please limit risk to affordable levels. The best way to do that is to be very careful when deciding the size of each position.

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