If you only invest in stocks you probably think you have a good
idea about your risks. But the fact is, if you're a long-only stock
investor, you're actually taking on more risk than almost any other
type of investor out there.
Because as soon as you buy a stock, you're always assuming a 100%
total loss as your worst case scenario.
And while you probably don't believe it - with options, you can
control with precision the amount of risk and type of risk you wish
to take in any given trade and in any situation.
Yes - really. You can control your risk tolerance down to a single
percentage point - or as high as you'd like, and everything in
between. And the rewards tend to be commensurate - low risk
generally means low reward.
One of my favorite ways to manage my risk is selling vertical
call/put spreads like I do in the
Let me explain.
An investor, who only trades stocks or ETFs (not options) is
bullish, would simply buy a stock - let's say for $50.
At the same time I sell a 44/42 vertical put spread (which is a
strategy that bets the same $50 stock will stay above $44 by
options expiration) for $.25 ($1.75 is max risk).
The stock trader picked correctly and the stock rises to $53 by
options expiration of the vertical put spread (let's say 30 days)
that I traded. However, even by making the right call the stock
trader still only makes $3 or 6 percent, but I would have made 14.2
percent on my vertical put spread.
If the stock stayed at $50, the stock trader would have made
absolutely nothing (while tying up much more of his capital than I
would have to with my vertical put spread). I still would have made
14.2 percent on my vertical put spread.
If the stock dropped to $44, the stock trader would have lost $6 or
12%, and I would have still made the 14.2 percent because the stock
did not close below $44, the short strike of my vertical put
As you can see my "probability of success" is greater, but I also
limit my return at 14.2 percent.
I don't mind making that sacrifice because what are the chances
that the stock will climb 14.2 percent or $7.10 over 30 days?
And remember, if the stock does rise that quickly over by the time
my vertical put spread expires what is the likelihood that you are
actually going to hold on to the stock?
Many traders would have locked in gains at 5 percent, 8 percent or
even 10 percent.
The bottom line is that options get a bad rap, mostly because they
are vastly misunderstood by most professionals in the financial
world. And if they are vastly misunderstood among financial
professionals, how in the world should the retail trader or
investor expect to learn about the effectiveness and logical nature
of using options?
In many cases, with certain options strategies (long call), the
inherent greed of most investors deters them from capping their
profits by using a spread strategy. Even if the chance of success
is tenfold of what it would be if you bought a stock or even a long
That is not my game in the
portfolio. I choose to hit a ton of singles and doubles with a high
rate of success.
I use statistics to increase my chances of success. Given my
aforementioned example, why would anyone choose to buy a stock?
Buying stock can take a tremendous amount of capital outlay and
only has a 50/50 chance of success. Selling a vertical spread only
takes a fraction of the capital and allows me to choose my rate of
success based on the short strike that I choose to trade. In my
example I chose $44 which has over an 80 percent chance of success.
Not even casino owners get that type of edge. As a seller of
options, I do.
So if you're interested I hope you'll take a look at my Options
Advantage service. Learn the intricacies of how to effectively
trade options. This is a new way to trade options, one that is
essentially new to the retail public and it is my goal to teach
anyone and everyone willing to listen how to use options in their
daily investing lives.
Editor and Chief Options Strategist